A discounted cash flow model assumes the enterprise survives to generate the cash flows you have projected. For a distressed company that assumption is exactly what is in question, and a conventional DCF therefore systematically overstates value. Damodaran's treatment of this problem is the clearest available, and it is free.
Why the standard model fails
A DCF discounts projected cash flows at a rate reflecting their risk, with a terminal value representing the business in perpetuity. Both components presume continuity. For a company with a material probability of failing before the projection period ends, the model prices a set of cash flows that may never occur, and the terminal value — typically the majority of the computed value — becomes actively misleading.
The same defect afflicts forward multiples. Projecting EBITDA five years out and applying a healthy-company multiple produces a large number that is valid only if good health is guaranteed. Where there is a significant probability of adverse outcomes in the interim, the estimate must be reduced to reflect it.
Two ways to fix it
The adjusted DCF approach values the company as a going concern, then explicitly subtracts the probability-weighted loss from distress: multiply the probability of failure by the difference between going-concern value and distress sale proceeds, and deduct. This requires estimating a default probability, for which bond spreads, ratings-implied default rates, and the rating agency default studies all provide anchors.
The scenario approach builds several complete cases — reorganisation, sale, liquidation — assigns probabilities, and computes an expected value. It is more transparent about what is being assumed and it produces the distribution rather than just its mean, which is more useful when you are deciding which tranche to buy. Most practitioners use it.
Multiples in distressed contexts
Comparable company multiples remain useful but require care. Peers should be selected on business model and cyclical position, not just sector. Current trading multiples of healthy peers describe a company that is not distressed, so applying them to a distressed target imports an assumption of successful restructuring. Precedent transactions in distressed situations — 363 sales, restructuring plan valuations from disclosure statements — are more relevant comparables and are publicly available on dockets.
Whatever the method, apply it to defensible run-rate EBITDA rather than to reported adjusted EBITDA. The adjustments made in a lender presentation are advocacy.
Valuation as a contested question
In a Chapter 11 case, valuation is not an academic exercise but a litigated one, because it determines who receives the reorganised equity. The debtor's financial advisor produces a valuation. The UCC produces another. An ad hoc group produces a third. The judge may hold a valuation hearing and choose among them, and the difference between the high and low estimates is routinely a multiple of the disputed recovery.
For an investor, this means your valuation must survive adversarial scrutiny. Build it so that each assumption can be defended by reference to something observable — a comparable transaction, a disclosed contract, an industry data point — rather than to judgment alone.