How to Value Distressed Companies
Valuing distressed companies can be challenging due to the unique circumstances they face. Traditional valuation methods may not fully capture the complexities and risks associated with distressed situations. However, several approaches and factors are commonly considered when valuing distressed companies. Here are some key points to consider:
- Asset-Based Approach: This approach focuses on the company's tangible and intangible assets. The valuation considers the break-up value of the company's assets, which assumes a forced sale within a short timeframe. It may also involve assessing the value of intellectual property, brands, and other intangible assets that could be sold separately. In certain cases, the value of a distressed company may be estimated based on its forced sale value. This approach involves estimating the proceeds that would be generated from selling off the company's assets and settling its liabilities. It assumes a worst-case scenario in which the company is unable to continue operating as a going concern. The value of the business can also be estimated based upon the cost to recreate or replace the assets of the company although this doesn’t take into account the value of the business as a going concern.
- Discounted Cash Flow (DCF) Analysis: DCF analysis estimates the present value of a company's future cash flows. In the case of distressed companies, projections may need to be adjusted based on the company's specific circumstances, such as expected changes in revenue, cost structure, or market conditions. Adjustments may also be made for potential risks or uncertainties. These adjustments must take into account the range of outcomes and the probabilities for each course of action including outliers such as the estimate life of the enterprise. The estimated life of the business may depend upon the resources required to turnaround the company, whether the distress is financial or economic and therefore outside the control of the company. The discount rate used to arrive at a value should be based on the sector and then re-leveraged based on the financial and operating risks associated with the company, including the strength of management. Cost of borrowing should be based the financial characteristics of the company and included in the cashflow with leverage to reflect the servicing capacity of the business and sector norms. While most distressed companies will be suffering losses, account should be taken of a return to profitability and the tax rate that would apply as thus will impact the value over the life of the business.
- Turnaround: The valuation of a distressed company may also take into account its potential for successful turnaround and future profitability. Factors such as the quality of management, market opportunities, competitive advantages, and strategic initiatives can influence the valuation. This approach considers the company's ability to recover from its distressed state and generate positive returns in the future and tends to be highly subjective and its impact on the discount to be applied to DCF analysis.
- Market-Based Approach: The market-based approach compares the distressed company to similar companies that have recently been sold or valued. It considers relevant financial metrics and transaction multiples in comparable industries or sectors. However, finding suitable comparable companies in distressed situations can be challenging, and adjustments may be necessary to account for differences in financial health or other factors on which the multiple should be applied. Such an approach may not be appropriate when valuing a distressed company.
- Market Sentiment and Investor Demand: The valuation of distressed companies can also be influenced by market sentiment and investor demand. The perception of risk, prevailing market conditions, and the level of interest from potential buyers or investors can impact the valuation. In distressed situations, the availability of financing or access to capital can also influence the valuation outcome.
- Testing the Market. The best way to value distressed companies is to test the market by running a sales process even over a shorten period of time (Accelerated M&A). Liquidity can be a significant factor when considering this option.
It’s important to note that valuing distressed companies is often a complex and nuanced process. It may require the expertise of professionals with experience in restructuring, distressed asset valuation, and financial analysis. Additionally, specific legal and regulatory frameworks may also impact the valuation process for distressed companies.