The Ultimate Guide to Valuing a Troubled Company
In today’s highly competitive business environment, many companies have problems maintaining profitability.
Nevertheless, they often need valuations for obtaining a loan, preparing for a buyout, or other reasons.
Valuing a company experiencing financial difficulties can, however, be tricky. If a valuator chooses the wrong method and assumptions, the value may appear to belie the company’s financial woes.
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In addition, the owner of a troubled company often tries to up the value by citing the circumstances that led to the problems and suggesting potential remedies.
Even if some of these ideas are valid, they are merely hypothetical, and valuators cannot take them into account when attempting to reach an accurate value.
Let’s look at a few points to consider.
Choosing a Method
Generally, valuations are based on either the market (market value), underlying assets, or earnings. Market-based approaches use comparable transactions to derive an entity’s value.
While in certain situations this can be a reliable method, it is not the best approach to value a troubled company -- simply because a valuator is unlikely to find another company of the same type experiencing exactly the same kinds of financial difficulty.
The approaches more suited to valuing a troubled company are based on income or cash flow. Sometimes valuators discount future returns, capitalize past earnings, or use a weighted average of these methods to reach a value.
Such methods usually employ a discount or capitalization rate based on the rate of return that an investor wishes to receive in light of the risks involved. When the risk is higher, the discount rate and the amount the investor wants to earn both increase accordingly.
A Better Approach
A better approach is to develop and implement a turnaround plan, then use projected future returns to estimate the value. But valuators must be cautious in evaluating the viability of the proposed turnaround plan and its probable efficacy in returning the company to profitability. Among the questions a valuator must ask when projecting future cash flow are:
At what rate will sales increase (if at all)?
Will expenses follow sales?
Are direct costs to produce one dollar of sales likely to increase or decrease?
The answers to these questions depend on how well the turnaround plan works.
Understand the Special Considerations
Keep in mind that a dollar received today is worth more than a dollar received at some future date. The terms of payment are thus as important as the amount paid.
As always in a valuation, many elements are involved in valuing a financially troubled company. This brief summary should help you understand some of the special considerations for this type of valuation.
Qualitative Criteria Can Influence Value
The valuator considers qualitative criteria to determine the amount of risk. Some of the more important qualitative criteria for evaluating a going concern emerging from financial difficulties are:
What is the overall outlook for the company’s industry over the next 10 years? Will the industry enter a growth period, remain stable, or decline?
How easily can potential competitors enter the market?
How effective is the management? Does the welfare of the company depend too heavily on certain key personnel?
What is the company’s market share?
Does the company rely on only a few key customers and suppliers?
How does the company’s financial risk compare to its healthier competitors?
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