What is valuation? From the first days on this planet humanity evaluates. Ancient people thought about: how many fruits and vegetables they should take in exchange for a meat and not take too few. With currency system development, everything has been evaluated in money. But the same problem stayed: how to find fair value and not to make yourself a fool. Thousand years passed, many concepts, “price” theories were devised, but there is still no unique approach. And probably as physics goes more and more deeply into substance, failing to find ultimate particle, economists face or do the same. Often during the course of business many companies are in a situation wherein they find it difficult to maintain their normal course of business. In such cases they are termed as distressed firms. However, show must go on. Either someone with financial power buys them out or the firm will be liquidated. It is an interesting and sophisticated work. Ascertaining the value of a distressed company is very crucial for those who are interested in the company. Interested parties require this information to determine what the actual underlying value of the business is and what discounts are to be made over this value to get an accurate picture of the business value of the firm. First of all, in this article we will pay attention for distressed company valuation as special case, which required its own approach. Of course, usual valuation techniques can be used for distressed companies, but these results are very unstable. Various studies have shown that using valuation techniques for the valuation of distressed firms have produced results which are in the range of 20% to 300% of the actual value. This is a large difference and is not acceptable in any business transaction. For example in the case of Sahara Airlines there was a large difference in the bids of Jet Airways and Kingfisher Airlines. This emphasizes the underlying difficulty in estimating the value of distressed firms. Valuation technique may result in 300% of the true value of the distressed firm True Value of the Firm 20% Estimate of the firm’s value through valuation techniques. VALUATIONS In finance, valuation is the process of estimating the potential market value of a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., Bonds issued by a company). Valuations are required in many contexts including investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.
There are several methods which are widely used in the industry for analysing the value of any firm. Many-a-times several methods are used to get a better idea of the underlying value of the firm. The focus of this paper is valuation of distressed assets, so we will not go into details of the traditional approaches DISTRESSED FIRMS One of the simplest definitions for a distressed firm is any firm that in near future won’t be able to fulfil its obligations. Firm in this case may either go bankrupt and consequently liquidate its asset or it may undergo restructuring. In any case it is important to identify the true value of the firm. Other definition of a Distressed Asset is as follows. Assets are usually considered “distressed” when their value is severely depressed for a reason particular to the issuer and not because of general market conditions.
Financial distress is typically an unanticipated event. It is really difficult to identify the potential firms which are on the verge of default. But there are peculiar indicators which can give an idea about the health of the firm. Businesses transitioning along a continuum of financial health from going concern to distressed, often exhibits one or more of the following characteristics:
A high debt to Equity Ratio and debt to Asset ratio is a first signal of the upcoming problem. Sometimes it may be due to bad management or it may be due to aggressive Merger and Acquisition strategy. For example after the acquisition of the Tata Steel, its balance sheet is over leveraged.
If a firm fails to meet its debt or other obligations on time then it is an indication of poor health of the firm or poor management of resources.
Many a times due to lack of systems and procedures there is a lack of internal control in the firm.
Sometimes a company gets a major chunk of its business from one key customer. Similarly there is one key supplier who supplies a raw material critical for the production. In such cases if there is a loss of such customer or supplier then entire operations of the company are in jeopardy. This is what Reliance did when it was the single supplier of one of the critical raw materials for plastic industry.
If the management of the company is having a short term approach and is looking for quick fix solutions instead of long term solutions.
Discovery of fraud is a very good indication of an unhealthy firm. For example in the case of Satyam, when its erstwhile promoter Ramalinga Raju tried to get Maytas Infra under Satyam, many analysts were sceptical about the company’s health.
Sometimes companies get most of their revenue from one single product. Also many companies tend to invest all their resources in a single product. In such cases if the product fails then the entire firm is doomed to fail.
If a firm fails to innovate and continues its business with same model then after sometime its business model will become redundant and obsolete. Firms with obsolete business models are always next in line to fail.
Many industry sectors have a common phenomenon of cyclical downturn. There is a recession in the industry after every cycle of say 10 or 15 years. Strong companies are able to overcome such scenarios but the weaker players succumb to it.
In some sectors proportion of raw material cost is a very high. In such cases if the prices of raw materials jump steeply then the business becomes unviable. An example of such sector is Airlines industry which is highly dependent on the prices of the OIL.
External factors may also influence the health of the company. These may be macro level factors like government policies or it can be events like terrorist activities. For example health of the hospitality industry is directly related to influx of tourists which in turn is related to peace in the country. After every major terrorist activity, Indian Hotel companies see a steep decline in their Occupancies. Although these characteristics are true for any distressed firm, but it doesn’t means that if any firm shows any of these characteristics then it is going to bankrupt. For example a firm may make payment defaults but it doesn’t means that the firm will have to be liquidated now. In fact in such cases the above characteristics just give a preliminary indication that finances of a particular firm are not in place. In such cases a deeper analysis of the firm’s financials is required.
Additional adjustments to a valuation approach, whether it is market-, income- or asset-based, are necessary in almost all the instances. These adjustments help in gauging a more accurate valuation for a distressed Asset. These involve: Excess or restricted cash Other non-operating assets and liabilities Lack of marketability discount Control premium or lack of control discount Above or below market leases Excess salaries in the case of private companies. There are other adjustments to the financial statements that have to be made when valuing a distressed company. Typical adjustments used to recast the financial statements for a distressed company include: Working capital adjustment Deferred capital expenditures Cost of goods sold adjustment Non-recurring professional fees and costs Certain non-operating income/expense items ADAPTING DISCOUNTED CASH FLOW VALUATION TO DISTRESS SITUATIONS When will the failure to consider distress in discounted cash flow valuation have a material impact on value? If the likelihood of distress is high, access to capital is constrained (by internal or external factors) and distress sale proceeds are significantly lower than going concern values, discounted cash flow valuations will overstate firm and equity value for distressed firms, even if the cash flows and the discount rates are correctly estimated. In this section, we will consider several ways of incorporating the effects of distress into the estimated value.
In traditional valuation, we estimate expected values for each of the input variables. For instance, in valuing a firm, we may assume an expected growth rate in revenues of 30% a year and that the expected operating margin will be 10%. In reality, each of these variables has a distribution of values, which we condense into an expected value. Simulations attempt to utilize the information in the entire distribution, rather than just the expected value, to arrive at a value. By looking at the entire distribution, simulations provide us with an opportunity to deal explicitly with distress. Before we begin running the simulations, we will have to decide the circumstances which will constitute distress and what will happen in the event of distress. For example, we may determine that cumulative operating losses of more than $ 1 billion over three years will push the firm into distress and that it will sell its assets for 25% of book value in that event. The parameters for distress will vary not only across firms, based upon their size and asset characteristics, but also on the state of financial markets and the overall economy. A firm that has three bad years in a row in a healthy economy with rising equity markets may be less exposed to default than a similar firm in the middle of a recession. The steps in the simulation are as follows: Step 1: The first step involves choosing those variables whose expected values will be replaced by distributions. While there may be uncertainty associated with every variable in valuation, only the most critical variables might be chosen at this stage. For instance, revenue growth and operating margins may be the key variables that we choose to build distributions for. Step 2: We choose a probability distribution for each of the variables. There are a number of choices here, ranging from discrete probability distributions (probabilities are assigned to specific outcomes) to continuous distributions (the normal, lognormal or exponential distribution). In making this choice, the following factors should be considered: The range of feasible outcomes for the variable; (e.g., the revenues cannot be less than zero, ruling out any distribution that requires the variable to take on large negative values, such as the normal distribution). The experience of the company on this variable. Data on a variable, such as operating margins historically, may help us determine the type of distribution that best describes it. While no distribution will provide a perfect fit, the distribution that best fits the data should be used. Step 3: Next, the parameters of the distribution chosen for each variable are estimated. The number of parameters will vary from distribution to distribution; for instance, the mean and the variance have to be estimated for the normal distribution, while the uniform distribution requires estimates of the minimum and maximum values for the variable. Step 4: One outcome is drawn from each distribution; the variable is assumed to take on that value for that particular simulation. To make the analysis richer, we can repeat this process each year and allow for correlation across variables and across time. Step 5: The expected cash flows are estimated based upon the outcomes drawn in step 4. If the firm meets the criteria for a going concern, defined before the simulation, we will then discount the cash flows to arrive at a conventional estimate of discounted cash flow value. If it fails to meet the criteria, we will value it as a distressed firm. Step 6: Steps 4 and 5 are repeated until a sufficient number of simulations have been conducted. In general, the more complex the distribution (in terms of the number of values the variable can take on and the number of parameters needed to define the distribution) and the greater the number of variables, the larger this number will be. Step 7: After every simulation, a value will be generated depending upon whether it is a going concern or a distressed firm as the case may be. To calculate the value of the firm, take the average of all the simulated values. From simulation, probability of default can also be assessed along with the effects of distress on the underlying value of the firm. But there are some limitations to this approach. The most basic limitation is the identification of the inputs which are required for the analysis. In practice, it is difficult to choose both the right distribution to describe a variable and the parameters of that distribution. If the assumptions are not proper then although the outcome may look impressive but it will be of no value. Therefore, complete care should be taken to extract the maximum results.
Discounted Cash Flow valuation can be adjusted to reflect the effects of firm’s distress on the valuations of the firm. We will use both Expected cash flows as well as discount rates to get an accurate valuation of the distressed firm. Estimating Expected Cash flows To consider the effects of distress into a discounted cash flow valuation, we have to incorporate the probability that a firm will not survive into the expected cash flows. In its most complete form, this would require that we consider all possible scenarios, ranging from the most optimistic to the most pessimistic, assign probabilities to each scenario and cash flows under each scenario, and estimate the expected cash flows each year. Where it is the probability of scenario j in period t and Cashflowjt is the cashflow under that scenario and in that period. These inputs have to be estimated each year, since the probabilities and the cash flows are likely to change from year to year. A shortcut, albeit an approximate one, would require estimates for only two scenarios – the going concern scenario and the distress scenario. For the going concern scenario, we could use the expected growth rates and cash flows estimated under the assumption that the firm will be nursed back to health. Under the distress scenario, we would assume that the firm will be liquidated for its distress sale proceeds. Our expected cash flow for each year then would be: Where Going concern, t is the cumulative probability that the firm will continue as a going concern through period t. The probabilities of distress will have to be estimated for each year and the cumulative probability of surviving as a going concern can then be written as follows: Where distress, it is the probability that the firm will become distressed in period t. For example, if a firm has 20% chance of distress in year 1 and a 10% chance of distress in year 2, the cumulative probability of surviving as a going concern over two years can be written as: Cumulative probability of survival over 2 years = (1- .20) (1 – .10) = .72 or 72%
In conventional valuation, we often estimate the cost of equity using a regression beta and the cost of debt by looking at the market interest rates on publicly traded bonds issued by the firm. For firms with a significant probability of distress, these approaches can lead to inconsistent estimates. Consider first the use of regression betas. Since regression betas are based upon past prices over long periods (two to five years, for instance), and distress occurs over shorter periods, we will find that these betas will understate the true risk in the distressed firm. With the interest rates on corporate bonds, we run into a different problem. The yields to maturity on the corporate bonds of firms that are viewed as distressed reach extremely high levels, largely because the interest rates are computed based upon promised cash flows (coupons and face value) rather than expected cash flows. The presumption in a going concern valuation is that the promised cash flows have to be made for the firm to remain a going concern, and it is thus appropriate to base the cost of debt on promised rather than expected cash flows. For a firm with a significant likelihood of distress, this presumption is clearly unfounded. As an extreme example, consider estimating a beta for Enron at the end of 2001. The beta estimate from Bloomberg, using 2 years of data, was 1.45. Over three-quarters of this period, Enron was viewed (rightly or wrongly) as a healthy firm with positive earnings. It is only in the last part of the regression period that you see the effects of distress on stock prices and the debt to equity ratio of the firm. What are the estimation choices for distressed firms? To estimate the cost of equity, we have two options that provide more reasonable estimates than regression betas:
Instead of using regression betas, we could use the bottom-up unlevered beta (the weighted average of unlevered betas of the businesses that the firm operates in) and the current market debt to equity ratio of the firm. Since distressed firms often have high debt to equity ratios, brought about largely as a consequence of dropping stock prices, this will lead to levered betas that are significantly higher than regression betas. If we couple this with the reality that most distressed firms are in no position to get any tax advantages from debt, the levered beta will become even higher. Levered beta = Bottom-up Unlevered beta (1 + (1- tax rate) (Debt to Equity ratio)) Note, though, that it is reasonable to re-estimate debt to equity ratios and tax rates for future years based upon our expectations for the firm and adjust the beta to reflect these changes. Distress factor Models In addition to the standard factor for market risk, we could add a separate distress factor to the cost of equity. In effect, this would make the cost of equity for distressed firms much higher than healthy firms in the same business. In fact, some have attributed the higher returns earned by firms with low price to book ratios to distress; low price to book stocks, they argue, are more likely to be distressed. Other studies, however, contest this notion by noting that portfolios of distressed firms have earned lower returns than portfolios of healthy firms historically. To estimate the cost of debt for a distressed firm, we would recommend using the interest rate based upon the firm’s bond rating. While this will still yield a high cost of debt, it will be more reasonable than the yield to maturity when default is viewed as imminent. To compute the cost of capital, we need to estimate the weights on debt on equity. In the initial year, we should use the current market debt to capital ratio (which may be very high for a distressed firm). As we make our forecasts for future years and build in our expectations of improvements in profitability, we should adjust the debt ratio towards more reasonable levels. The conventional practice of using target debt ratios for the entire valuation period (which reflect industry averages or the optimal mix) can lead to misleading estimates of value for firms that are significantly over levered.
The biggest roadblock to using this approach is that even in its limited form, it is difficult to estimate the cumulative probabilities of distress (and survival) each year for the forecast period. Consequently, the expected cash flows may not incorporate the effects of distress completely. In addition, it is difficult to bring both the going concern and the distressed firm assumptions into the same model. We attempt to do so using probabilities, but the two approaches make different and sometimes contradictory assumptions about how markets operate and how distressed firms evolve over time. INVESTING IN DISTRESSED ASSETS The most common situation of a distressed asset is a commercial loan on which the issuer has defaulted on payments of principal or interest. Distressed asset investing generally, and emerging markets distressed investing in particular, are undertaken by a small number of firms. Implementing the strategies successfully requires specific skills and particular economic structures. For those firms with the appropriate professional skills and capital base, however, the strategies can be extremely profitable. Investing in such assets has become particularly more popular after the recession wherein many firms are in distressed state. There is still huge underlying value in assets of many such companies and proper valuation of these dark horses can lead to windfall gains for investors.
Distressed investments can be categorised by the type of exit foreseen. In other words, what is the strategy for cashing out? Event-driven distressed investments. These are directional investments in distressed and special event situations in sovereign and corporate securities, for which some event is on the horizon which will transform the nature of and increase the value of the assets. The event can be a restructuring of a company’s or country’s debt, a liquidation of a company’s assets, or a buyback of outstanding debt by an issuer or by individuals. Capital gain from the investment is provided either through re-pricing upon occurrence of the event, or through the proceeds of a restructuring. Valuation-driven distressed investments. These are directional investments made in distressed situations where a transformative event is not at sight. The exit may be either through the market (re-pricing due to credit strengthening), cash flow, or an event (re-pricing upon an event or through the proceeds of a restructuring). Some investors may buy distressed assets simply because the price seems too good to pass up, but this can be dangerous: what is cheap today may be cheap tomorrow, unless there is a reason for the value to rise. Valuation-driven investments should therefore be made only when a clear reason for triggering an increase in value can be ascertained, even if the timing of the increase is uncertain. Distressed investing usually involves the purchase of debt, but equity analysis is relevant for two reasons. First, the assets are usually non-performing, and therefore the theoretical yield is less important than the potential for capital gains; successful distressed debt investments will produce equity-like returns. Second, equities are increasingly being distributed to creditors as part of the package of assets coming out of debt restructurings; in this way, control of a company’s debt pre-restructuring may later lead to equity control. Distressed investing strategies may be combined with other complementary but uncorrelated investment strategies in liquid instruments. This can diversify portfolio risk, create hedging opportunities, and provide useful liquidity. Distressed investments are rarely possible to sell short, so any hedges for long positions or outright short positions must be undertaken in the context of a different, liquid investment strategy.
A very famous Thai Oil Company at one point of time in the late 1990s had over $2 billion of debt outstanding. Company was not able to meet the obligations and had defaulted. After the default the market price of the debt fell and it was being traded at 30% of the actual face value. But here the company reorganized its finance and made a smart move. The company itself bought almost 50% of its outstanding debt at a price between 50-90% of the original face value. Company also agreed on a debt restructuring, in which it issued clean debt and gave A½ of its equity to creditors. Thus improvements in the business and decrease in the outstanding debt led to rerating of its debt ratings. Now the debt was rating at par and thus made it’s once worth less equity very valuable. CONCLUSION Distressed firms, i.e., firms with negative earnings have a strong likelihood of failure; present a challenge to analysts valuing them because so much of conventional valuation is built on the presumption that firms are going concerns. But in the case of distressed firms this very assumption doesn’t holds true. In this paper, we have examined how discounted cash flow has to be adjusted with respect to the valuation of distressed assets. With discounted cash flow valuation, we suggested two ways in which we can incorporate distress into value – simulations that allow for the possibility that a firm will have to be liquidated and modified discounted cash flow models, where the expected cash flows and discount rates are adjusted to reflect the likelihood of default With relative valuation, we can adjust the multiples for distress or use other distressed firms as the comparable firms. In addition to this in the last section we talked about investing in such assets. From this we can say that trading in distressed assets that too particularly in emerging markets can be highly profitable, given the growth prospects naturally existing in such regions. But before dealing with distressed firms it is very important to understand how to evaluate such firms. If the valuations can be done accurately then it can lead to windfall gains.
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