Creditor committees use valuation reports in a variety of ways, and it is important for the lawyer or financial advisor to help the committee understand how to read and evaluate a valuation report. Among other things, valuation reports help assess the treatment of creditors in a proposed plan, determine the appropriate disposition of an asset or division, evaluate debt capacities and estimate potential recoveries. Although valuation results are used to make critical decisions on how the committee will proceed, valuation conclusions are more art than science and deserve critical analysis and review. By understanding the limitations of common valuation methods, advisors can appreciate the inherent uncertainty in the valuation process, evaluate the quality of conclusions, review the appropriateness of the methodology used, and determine the weight the valuation should be given in reaching a decision.
At the outset, a determination must be made regarding whether the target company's value is greater as an operating entity or as the subject of a liquidation. To value an operating entity courts generally recognize two primary valuation methodologies, with others used in selective cases: the intrinsic value method and the relative value method. The intrinsic approach values an asset based on its expected future cash flows; in essence, it attempts to answer the question of what the buyer should pay for the assets rather than what the market will pay for the assets. Proponents of the intrinsic approach argue that although the emotional perceptions of buyers and sellers determines market prices, ultimately valuations should have a fundamental foundation based on expected cash flow. Alternatively, relative valuation considers how the marketplace values similar assets; in essence, the approach determines what the market would pay for the asset. The relative valuation method attempts to determine the value by locating a set of comparable companies that have public valuation information, such as stock trading values or recent transactions, and compares the financial performance of the company or assets being valued.
The primary intrinsic valuation method is the discounted cash flow (DCF) valuation. The DCF approach determines the value of an asset based on the present value of all future expected cash flows derived from the asset. The analysis includes forecasting free cash flows into the future for the life of the asset or business and then discounting these cash flows at an appropriate rate taking into account the time value of money and the riskiness of the cash flows. The “time value of money” principle states that a dollar today is worth more than a dollar tomorrow because (1) inflation reduces the future purchasing power of the dollar, (2) the uncertainty involved in receiving the dollar increases with time and (3) the opportunity cost of receiving the dollar later—meaning that a dollar today is worth more than a dollar in one year because it can be invested during that timeframe. The discount rate should reflect the riskiness of the borrower and inflation expectations.
Although the DCF approach is preferred when valuing firms or assets whose cash flows and cost of capital can be reliably estimated, DCF inputs are difficult to determine. For example, what is the life span of a corporation? How do you forecast cash flows 10 years out? What is the appropriate discount rate? There is a considerable amount of subjectivity in selecting each of these inputs, and each input can have a dramatic effect on the outcome. In addition, the DCF method may not fully reflect the value of non-cash flow producing assets such as idle or underutilized equipment. These assets should be considered separately and included in a full analysis.
The relative valuation approach relies on the market value of comparable firms that are publicly available, through either announced transactions or publicly traded stock information. Rather than forecasting future cash flows, the available public market data is used to determine what buyers are currently paying for comparable businesses or assets. Relative valuation requires publicly available information on transactions and a standardized measure of value such as Price/Earnings, Price/Book, Price/Cash Flow, or Price/Dividends ratios. Once those ratios are determined for the comparable companies, they can be applied to the target’s data to yield a comparable value. For example, if company A has a PriceA/EarningsA ratio of 15A, then you can back-solve for company B’s price as follows 15A x EarningsB = PriceB. Similarly-situated publicly-traded company statistics are commonly compared to the valuation target both individually and as an industry average. Similar private and public transaction data is also used, in addition to historical statistics of the valuation target. Relative valuation is most effective when there are multiple comparable companies with available information, but it is less useful for unique firms or firms with negative or insignificant earnings. Thus, the quality of comparable companies and their similarities to the target is essential in determining the reliability of a particular valuation.
There are several basic but common misconceptions that should be kept in mind when reading a valuation report. Valuation is more of an art than a science, so do not let the scientific-looking formulas and ratios confuse the creditor. Valuation is not precise, so be wary of a precise answer. Remember also that valuations are biased, so the right questions to ask are “what is the bias?” and “how is it reflected?.” When analyzing a DCF in particular, it is important to remember that small assumption changes regarding the discount rate, capital structure, cash flow forecast and terminal value can have a significant impact on the valuation outcome. Similarly, when analyzing a relative valuation, it is important to question the comparables. Are the comps appropriate? Are any left out? How were they weighted? Were they adjusted for the target’s leverage ratio? Were there a sufficient number of transactions?
There are sophisticated variations of the “relative and intrinsic value” approach, and a careful reading of the valuation report will help educate the reader on what assumptions are used and how they are used. A high-quality valuation often explains what assumptions were used and the weaknesses in those assumptions. Valuation is a subjective and assumption-filled analysis that is easily slanted and often presented with a level of certainty that the process cannot possibly provide. Instead of focusing solely on the conclusion of the report and treating it as a “fact,” a critical analysis of the report’s underlying assumptions and an understanding of the conceptual limitations behind the valuation process are essential to determine the proper weight to be given to a valuation report in making important committee decisions.