Valuing the Financially Distressed Firm

<p>One of the most frequently debated yet least understood issues in business and law is the value of

a firm. The process of valuing a firm is even more complex and less understood when one adds to

the equation the fact that the firm is financially distressed or has even already filed for

bankruptcy.

</p><p>The initial issue that should be addressed is whether the firm's value should be derived as a

liquidation value or a going-concern value. Generally, the appropriate method depends on the

facts relevant to each specific case. For example, if creditors value a firm for the purpose of

deciding whether to support a reorganization, or alternatively to pressure for its liquidation,

valuations based on both a liquidation assumption and a going-concern assumption are typically

derived.

</p><p><i>Liquidation value</i> reflects the firm's expected proceeds, assuming the business is discontinued

and the assets are sold off piecemeal. The literature distinguishes between <i>orderly liquidation</i>

(assets are sold over a reasonable time period) and <i>forced liquidation</i> (assets are sold quickly,

often at an auction sale). Usually, a liquidation valuation can be estimated with more precision

than a financially distressed enterprise valued as a going-concern. The focus of this article is

the valuation of such a distressed company as a going-concern. Obtaining the fair market value

of such a firm based on a going-concern assumption typically requires the use of several key

methodologies.

</p><h3>Publicly Traded Comparables</h3>

<p>Valuation experts often use a multiple based on the firm's earnings before interest and taxes

(EBIT), frequently referred to as operating income. First, a group of publicly traded

comparable firms is identified and, based on that group, a most representative figure for the

ratio of enterprise value-to-operating income is derived. The enterprise value is simply the

sum of the firm's equity and its debt. Once this representative multiple has been obtained, the

operating income of the firm being valued is multiplied by the multiple to derive the firm's

enterprise value. Then to obtain the firm's equity, its debt is subtracted from the enterprise

value. Similarly, experts often use other multiples, such as earnings before interest, taxes,

depreciation and amortization (EBITDA), often referred to as operating cash flow. While the

method of comparables is extremely useful when applied appropriately, it is often impossible to

apply it to a financially distressed firm, particularly when the firm's operating income and

operating cash flow are negative, or even positive but unusually small. In such cases, experts

often tend to rely on a sales-based multiple. Unfortunately, while sales go hand-in-hand with

long-term profitability, the revenue multiple is less useful than the profitability- and cash

flow-based multiples. One way to overcome the negative EBIT and EBITDA limitation is to value

the firm at some future point in time (when the operating income and operating cash flow are

expected to be positive) and, if necessary, compute the present value of this figure discounted to

the time of the desired valuation date.

</p><p>One might also contemplate using distressed comparables. In general, based on our experience,

the financial ratios of financially distressed firms often have an inappropriate sign, are

unstable, and are subject to sharp variations over a short time period. Thus, they typically

should not be relied upon for valuation.

</p><h3>M&amp;A Transactions</h3>

<p>Valuation experts often use information from mergers and acquisition (M&amp;A) transactions

involving firms comparable to the one being valued. Similar to the valuation methodology based

on publicly traded comparables, the idea is to find a representative multiple based on the M&amp;A

targets and to then apply the multiple to the subject firm. However, in the case of distressed

companies, this methodology suffers from the same limitations as the comparable company

analysis. Specifically, a financially distressed firm often has a figure for net earnings,

operating income, or operating cash flow that is not meaningful (<i>i.e.,</i> negative, positive but

very small, or extremely unstable).

</p><p>One might contemplate using M&amp;A transactions involving similarly distressed companies.

However, in addition to the previously discussed limitation of a lack of meaningful profitability

measures, there is also the risk of having a wrong measure of purchase price. For example,

recently we reviewed the acquisition of a privately held firm that had been acquired by a

publicly traded firm. A careful review of the terms revealed that the CEO (and founder) of the

selling company was granted options in the acquirer's stock with certain provisions, and was

also awarded a contract for long-term employment. For a relatively small M&amp;A transaction,

adding the value of the options and the employment contract has the potential of changing the

actual purchase price and changing the acquisition-related multiples drastically as a result. In

addition, while elements such as options and employment contracts play an important role in

numerous transactions, they are even more likely to be of increased importance in M&amp;A

transactions involving distressed targets.

</p><h3>Discounted Cash Flow Methodology</h3>

<p>Given that each distressed company has its own unique circumstances, and certain of the other

valuation methodologies might potentially be limited, the relative importance of the discounted

cash flow (DCF) methodology is increased. Several issues should be addressed, including the

nature of the projected cash flows and the cost of capital and its components (the cost of equity

and the cost of debt). The <i>projected cash flows</i> are clearly crucial for the valuation. Naturally,

management is the source of the initial set of projected cash flows, and the valuation experts,

often assessing their reasonableness, will potentially adjust them appropriately. In the case of

a financially distressed (or already bankrupt) company, the situation is more complicated.

There is the possibility that the cash flows are consistently biased. For example, in a recent

article entitled "After Bankruptcy: Can Ugly Ducklings Turn into Swans?" (<i>Financial Analyst

Journal,</i> May/June 1998), we presented the results of our research on financial and

operational projections provided to the bankruptcy court by companies prior to their

emergence from bankruptcy. The results suggest that the projections are frequently (and often

greatly) overstated. The relevance of these results to valuation of financially distressed firms is

clear: management is obviously interested in getting the "green light," enabling it to keep

operating the business. As a result, the potential for a projection bias is clear. Nevertheless, it

is our experience that management often knows the firm and its industry better than its

advisors. In sum, while valuation experts' judgement and evaluation of the projected cash flows'

reasonableness is always required, in the case of a financially distressed firm, verification or

reassurance of the cash flow quality is generally warranted.

</p><p>Another important element of the DCF valuation methodology is the <i>cost of capital,</i> which is used

for discounting the projected cash flows. Obviously, once the news that the company is

financially distressed is out in the marketplace, its <i>cost of debt</i> increases significantly. If the

company does not have publicly traded debt instruments, the valuation expert might analyze

bonds of similarly distressed companies and derive their yield-to-maturity as a benchmark for

the cost of debt. Similarly, the <i>cost of equity</i> of the financially distressed company also

increases along with the news of its difficulties. The traditional finance literature asserts that

the cost of equity is generally higher than the cost of debt. It makes sense; shareholders are last

in line in the case of liquidation. However, it is important to realize that as the company

becomes increasingly distressed, the costs of debt and equity are both high, with the gap between

the two effectively decreasing. In other words, the debt of an extremely high-risk company

starts resembling equity. Moreover, certain frameworks often used for deriving the cost of

equity might potentially be of limited use in the case of a financially distressed company. An

example for such a framework is the measure of market risk (often referred to as beta or

systematic risk). Ordinarily, this measure assesses the volatility of the firm relative to the

overall market volatility. Clearly, under normal circumstances, a significant proportion of the

volatility in the value of a company is driven by economy-wide factors. However, once a

company is distressed, it has a momentum of its own only loosely related to market volatility,

even though it might well be distressed as a result of a recession. Therefore, the focus might

well shift from the traditional measure of market risk to the total risk facing the firm.

</p><p>In sum, while a valuation of a company is generally complex, valuing a distressed company is

further complicated by these and other additional unique considerations.

</p>