Bankruptcy Prediction, Equity Valuation and Stock Returns

Dear Colleagues,

Prior accounting and finance research is surprisingly silent on the importance of business failure risk in equity valuation. In contrast to standard reasoning by bond investors—for whom bankruptcy risk and bankruptcy recoveries are carefully captured in estimated promised yields—equity investors in general do not appear to pay much attention to the harsh “drop dead” risk implied by firm bankruptcies. Such ignorance can lead to severe overvaluations of company shares and hence a misallocation of capital to firms that are distressed or likely to become financially unstable. Company bankruptcies typically cause severe and non-reversable capital losses for equity investors, as well as other important stakeholders such as company suppliers, employees, and tax authorities. Properly understanding how bankruptcy risk should be incorporated in fundamental equity and firm valuation hence constitutes a crucially important issue in contemporary research, with a high relevance for professional investment practice. Knowledge of this kind can be of significant importance for the prevention of speculative stock market bubbles, as well as unwanted market crashes.

This Special Issue of JFRM encourages the submission of theoretical and empirical research addressing—but not limited to—the following research questions:

• How should bankruptcy risk be integrated in fundamental equity valuation?
• How can the option pricing framework of Merton (1974) be robustly applied in equity valuation modelling?
• How do financial analysts handle bankruptcy risk when making EPS (earnings-per-share) and EPS growth forecasts?
• How can expected values of valuation metrics, such as earnings and free cash flows prediction conditioned on firm survival, be used in fundamental valuation?
• What are the tax consequences to market investors when firms go bankrupt?
• Is bankruptcy risk a priced risk factor? To what extent is this risk overlapping with “small-minus-big” (size) or “high-minus-low” (book-to-market) risk commonly used in standard assessments of discounting rates?
• How can bankruptcy prediction models be improved? How can one, for example, incorporate macro-economic indicators or management characteristics in such models?
• What determines whether financially distressed firms become reorganized or put into bankruptcy?

Prof. Dr. Kenth Skogsvik
Prof. Dr. James A. Ohlson
Guest Editors

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• bankruptcy risk
• distress risk premium
• downside risk
• EPS forecasts
• failure prediction
• fundamental valuation
• return volatility
• stock returns