Contents - Index

Application of Merton's Model:  Example 2 GM
©2009 OS Financial Trading System


Currently GM is no longer trading under the ticker GM, instead it is the Motors Liquidation Ordinary Shares:


However, before trading as Motors Liquidation it was a distressed firm and using the following data we can value the old GM stock.
In the following exercise, first we will value GM stock from the information below assuming that the financial statements reflect the current value of total assets plus the current liabilities faced by GM.  This results of this analysis will lead us to question the value of GM's total assets as provided in the financial statements.   As a result, second, we will use the current market price of GM stock (at the time of this exercise) to infer what the market estimates the recovery rate to be from the listed total assets.   
So combined the exercise provides some important insights into problems associated with valuing distressed stocks.
GM Information
From the 10-K 2008 GM had the following Balance Sheet:  (Left to Right 2008, 2007, 2006, 2005 and 2004 in millions)



Source MSN Investor
The financial ratios reflect an equivalent story:


Source Morningstar.com
The current yield curve around April 17, 2009



Estimating Volatility from Historical Prices
From historical daily price data the annualized Volatility - estimated from 12-months of daily returns = 127.87%
Estimating Volatility from Option Prices  (April 17, 2009):
But next we check this number against what is implied from option markets:




January Implied volatility 101.26%.



September Implied volatility 118.78%.
We will use the September annualized volatility estimate of 118.78%
From shares outstanding we next convert all inputs to per share whenever relevant.


Option Pricing Inputs
Total Assets per share = $149.14
Total Liabilities per share = $290.265
Annualized Volatility = 118.78%
Risk free rate =  0.34%
Life = 151 days remaining so 151/365 = 0.41370
Spot price 1.86 (April 17, 2009)



Direct estimation for GM places a value of $16.1298 assuming that there is recovery of 149.14 of total assets per share and the large volatility.  
The market price of GM stock is substantially different and this reveals that the market assumes that the actual value of GM's assets is much lower than the book value.
Problem:  If GM stock is currently trading at 1.86, this implies that the implied asset value per share is:


From above we compute the implied asset value per share from the number that equates the predicted price to the actual stock price.  That is predicted price is:  1.860283 = 1.86 from the above screen when the volatility is 1.1878 etc.,.
We can then compute the total implied assets: $78.25*610.48 = $47,770 million
Given the current book value of total assets is $91,047 million then the implied recovery rate for total assets from the stock price is around 52%.  The balance sheet information for GM is provided below:




Accounting Measurement Issues and Valuing Distressed Firms
The above provides an important insight that when valuing a distressed stock the accounting statements will reflect liabilities relatively accurately as the face value is the legal obligation outstanding.  However, the asset side under a mixture of historical cost and fair value accounting may be misleading.  The above option pricing approach provides a useful technique for inferring what the market assesses the fair value of the assets to be.