Valuation of any company can be a tricky business. And when it comes to the business valuation of a distressed company, it becomes more challenging and crucial. A distressed company is a business that is facing issues in paying off its debts and other financial obligations. The reason for this could be illiquid assets, high fixed costs, and variability of revenues to economic downturns. This can lead to operational imbalance as there would be an increase in the cost of borrowings.
Distress is of two types- economic and financial distress. Factors causing economic distress include – cultural or technological changes, general economic recession, and wars or other geopolitical confrontations. Few of the factors are temporary, while others may bring a permanent change within the business landscape. Economic distress often ends up in financial distress. Financially distressed firms are unable to meet their financial obligations and paying back to their creditors. some of the characteristics of financially distressed companies are stagnant or declining revenue, shrinking margin, high leverage, ballooning interest costs, capital blockage, high customer and employee attrition, Shrinking or negative margins, Asset divestitures, Lack of confidence within the management.
It is vital to understand the nature of the business before conducting a business valuation process. There are few ways to ascertain whether a company is distressed or not. These are:
Various companies that are responsible for performing business valuation in Mumbai and Gurugram, follow these above-mentioned techniques.
1. Discounted Cash Flow Valuation (Modified):
The only difference between the modified and traditional discounted cash flow technique is that in this method adjustment for risk of default is taken into account while computing the cash flows. The formula for ascertaining expected cash flow is below:
Expected Cash Flow = SUM (Estimated cash flow under each scenario*Probability of respective scenario)
It should be kept into account that the adjustment for distress adjustment is a cumulative one and will have a significant impact on future cash flows.
The following procedures can be used for addressing the risk of distress in the discount rate:
i.) The bottom-up unlevered beta ought to be used and RE levered the use of the subject company’s present-day debt to equity ratio and the effective tax rate. Since distress agencies commonly have excessive debt to equity ratios and feature negligible effective tax rates (due to the fact they're loss-making), there levered beta which will be better will take into account the risk of distress.
ii.) Another choice is to estimate a distressed top rate that is to be added to the price of equity calculated using widespread measures. One of the approaches of computing the distress premium is to evaluate the company’s pre-tax cost of debt to the industry’s cost of debt. If the company has a pre-tax cost of debt of 16% and the same for the industry is 8%, the distress premium is 8%
2. Discounted Cash Flow Valuation Plus Distress Value
In this method, the calculation is done using the following formula:
Value of equity = DCF value of equity ongoing concern basis (1 – Probability of distress) + Distress sale value of equity (Probability of distress)
However, the following pointers should be considered during the business valuation process:
3. Relative Valuation
Among this technique, it is further classified into two approaches. These are:
The problem with the first approach is that there may not always be the right distressed companies to make comparisons with. For the second approach, it can be assumed the distressed enterprise might likely end up healthy in the future. Accordingly, an estimate is developed based on its future value that is then discounted again to arrive at a going-concern value to which the chance of distress and distress sale proceeds are added to reach the final value.
A distressed firm’s business valuation is a tricky task and requires a high level of expertise in judging the position of the company and ascertaining the level of risk associated. Multiple methods and techniques can be experimented with for each company. There are various firms that offer business valuation solutions for the clients and there are various companies that also opt for third-party valuation. It is on the will and understanding of what kind of valuation the client needs.
Resurgent India is a leading financial advisory that offers custom-made solutions regarding the business valuation of companies both healthy and distressed companies. It holds a team of professionals that are aware of the market trends and holds expertise in analysing the company’s position.