Valuation of a distressed company

In all over the world, startups are coming up in large numbers and on the other side probability of companies going into distressed state is also increasing. Start up gurus and companies have covered all the space in social media, news, discussions, events and even in newspapers. Companies are exploring new avenues to reach all corners of the potential market whereas distressed companies are trying to either recover or change hands to mitigate the risks of being drown. For taking exit from these companies, management need to understand their actual worth or valuation.

Valuation of such companies is not actually straight forward and analyst needs to do more work to value these companies as compared to other healthy companies. Most of the traditional approaches like discounted cash flow method, relative valuation etc. assumes going concern basis. If a company is in distressed state and there are bleak chances of its survival in coming years , valuation using these methods may provide over optimistic and incorrect valuations.

Further modifications in Discounted Cash Flow model (DCF ), relative valuation method etc. are required to value these distressed companies. Following options are available to value a distressed company:

§   We can use input for the DCF by considering probability of distress for each input and then need to find rectified cash flows as per the case. But calculating probabilities for all the inputs is a tricky task.

§   We may find valuation of the firm without impact of leveraging and then factor costs and benefits of the debt.

§   Valuation of the firm can be done normally assuming going concern basis and then we can adjust its value by considering probability of default using transition in bond ratings.

§   Simulation techniques are most sophisticated but very complex way of deriving value of any distressed company . Its application is quite cumbersome as we need to consider large scenarios for inputs. This model is tedious to apply and researches have shown that complex models like Monte Carlo are prone to errors and even after all precautions, they provide erroneous results.

In case of relative valuation, valuations can be done using either top line ( Net Operational Revenues) or EBITDA for distressed companies. Role of analyst in this case is quite important because he needs to drill down the multiple for the firm using his subjective understanding of the state of the distressed company.

Analyst can use available data related to distressed companies to value the company under consideration but this data is not readily available and even compiling of this data for all companies is not easily viable.

Just like I mentioned in case of DCF also, we may use probabilistic approach by valuing company normally and then adjusting it for probability of default. 

BRAND VALUATION

BRAND VALUATION

Brand valuation is an exercise to estimate the value of a brand. Now the question arises what is brand and motive of this article is to provide a glimpse of Brand Valuation. Brand is an intangible asset of the company which includes things like trademarks, logo, colors used, the way of packaging of goods etc. or in simple terms we can say it is face of the business. It provides a competitive advantage to the company against its competitors in the industry. Generally most of the entrepreneurs are of the view that it is only tangible asset like plant and machinery, land, building etc. which contribute to the growth of a company. But on a reality check, brands also have a heavy hand in this regards. Valuation of brands for a company comes in use by various stakeholders like corporates, government for taxation purpose or dispute resolution or licensing, by purchaser in case of slump sale, by bank or financial institution in case of providing loan, also by the management to develop business strategy accordingly. Brand valuation has to be based on principals like transparency, validity, reliability, sufficiency etc.

Specialists in the valuation industry use three approaches for Brand Valuation. These are elaborated as follows:

1. COST APPROACH METHOD

In this approach, the brand is valued in accordance with the cost incurred to develop a brand. It includes the present cost as well as the historical costs incurred from the point of generation of brand itself. It should be kept in mind that the historical cost should be taken as per their present values.

2. MARKET APPROACH METHOD

As the name suggests, this method value the brand in accordance with the value of similar brands present in the market. It implies the price at which the brand could be sold out in the market in the present date. This method is based on the principle that similar type of brands has comparable market value in the industry. Market approach method is easy to be employed but sometimes it is quite difficult to find out the brand of same nature.

3.  INCOME APPROACH METHOD

It is a type of futuristic approach. It takes into account the present value of the cash inflow to be generated in future date just because of goodwill of brand. Higher the value generated because of brand, higher will be this value.

To conclude this article……

Generally it becomes difficult to decide which of the above method is to be employed while valuating the brand, however the best way to value the brand is to employ all the above given method and to conclude it in accordance to the weights provided to each method.

Also along with the methods employed, the knowledge, experience of the valuer also plays a crucial role in brand valuation.

Thanks and regards

PureValue Research team

www.pvalueresearch.com

Risk Free Rate of Return

Risk free rate of return

“If you know the rate of return on any investment with almost 100 percent certainty, this rate will be risk free rate of return. But finding such a rate is not a cake walk as it requires deep dive into confusing world of interest rates.”

One school of analysts believes that if a security has no risk of default, it would be risk free rate of return. So now focus turns to “do we really have securities with zero risk.”?

No we don’t have but we assume that these rates would be risk free rate of return with almost but not exactly 100 percent certainty e.g. government securities, LIBOR etc. Further presence of sovereign risk complicates the process to find such a security and we cannot forget how LIBOR spread converged during financial crisis of 2008. So it is really hard to find such a rate.

They also assume that there is no reinvestment risk. If coupons on the bonds are invested at rates other than predicted, the security possesses reinvestment risk. But if a bond with long term e.g. 10 years or more time horizon is a zero coupon bond (with no reinvestment risk), then the return on that bond will be risk free rate of return.

Next point worth noticing is to evaluate whether required risk free rate of return is real or nominal. T-bills  and government bonds offer returns that are risk free in nominal terms, we have to adjust them for inflation because in countries like India with fluctuating inflation we may observe rapid and frequent changes in inflation and consequently in risk free rate of return.

 In practice, where demand for risk free rate is quite deep and broader like in valuations based on CAPM model, we may require risk free rate of return for a scenario  where we don’t have default free entities, in these cases it further becomes too difficult to estimate risk free rate of return.

We can argue that we will be able to fetch quite reasonable risk free rate of return estimates in these cases as well. We can observe longest and safest firm in the market and use the rate they pay on their long term borrowings in the domestic currency.

In a country where default risk of the government is quite high and it is not possible to use rate using any specific firm, we would rather use government borrowing rate less default spread of the bond issued by the government. To find default spread we can use default spread provided by credit rating agencies. Although these approaches are proxies to the risk free rate of return, but they are quite reasonable to be treated as risk free rate of return.

Thanks & Regards

PureValue Research Team

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Basics of Business Valuation

 Business Valuation -   The deal making value

Business valuation is the art and science of understanding the value and worth of any business. Generally the promoters , investors as well as the financial institutions wants to understand the value of business in order to take strategic decisions like sale of business , sale of certain stake of business, merger of business etc.

There are three approaches to Valuation - The asset approach, the income approach & the market approach.

The Asset Approach or the balance sheet approach is extremely useful for company with large asset base like real estate companies with land bank and may not be very useful for service industry companies like tech companies or e -commerce companies like Amazon, Flipkart, ebay etc.  This approach is based on historical data and does not take care of the future.

The Income Approach is useful for companies having a promising business story and having a good potential. This approach takes care of the future potential of business. Under this method discounted cash flow is the most popular method which takes care of the future cash flow of business. However this is a very sensitive model as it is based on various assumptions like the discount rate i.e. cost of equity or weighted average cost of capital through which the cash flow is to be discounted, the terminal growth rate and the systematic risk i.e beta factor of listed peers. A small change in any of these factors can drastically change the value of the business. However while applying the DCF methodology the first and the foremost step is to validate the projections with the help of peer companies.

The Market Approach 

The market approach in case of unlisted companies means applying the peer listed companies multiple to our company and valuing our unlisted company on the basis of market sentiment like PE Multiple, EBITDA Multiple, Mcap/ sales multiple etc.

At times it confuses us which method need to be applied while undertaking any valuation, however the best way is apply all the methods which suits your business model at first hand and then apply relevant weight based on the importance of the method to our business model. Applying different method is useful as its helps in making a sanity check.

One thing is of prime importance that there are different methods present to value a business; however the experience of the valuer play a most significant role as his experience can guide the client in deriving a fair value of business after looking into various aspect of business.

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PureValue Research Team

www.pvalueresearch.com

Holistic Approach towards Risk Management

Focus: Are we waiting for a new disaster to swallow all of our generated wealth or we are not sufficiently informed about all the facets of the risk management.

As Peter Drucker says:

“A business has to try to minimize risks. But if its behavior is governed by the attempt to escape risk, it will end up by taking the greatest and least rational risk of all: the risk of doing nothing”.

From last several decades corporate trend is to focus on corporate governance whereas, risk governance is perceived and inclined towards the financial risk management of the organizations. Events in the recent past in case of LTCM, Barings, Metallgeselschaft, Satyam, P&G etc. taught us strict lessons of improper risk management practices. Companies have now started realizing that it is only partial and biased view towards the risk management.

There are two angles to look at risk management. First, risk management has other unexplored dimensions like operational, strategic and hazard risks. Second angle points out that, risk is not only a negative outcome of an unwanted or unexpected event, but also, an indication of potential benefit at the cost of risk. How much proportion anyone wants to distribute between risk and opportunity is the need and taste of decision makers and art of the risk manager.

Earlier, much of the focus of risk management has been on financial risk management only by managing fluctuations in financial parameters like interest rates, exchange rates, inflation etc. Risk managers worldwide are now shifting gears to practice risk management in synchronized and holistic way which is termed as Enterprise Risk Management. In many organizations the purchase, treasury, HR, legal and finance departments handles risks independently at the department level, which is not an appropriate way. An organization-wide view of risk management may tremendously raise the efficiency to peak level and generate synergies among the departments.

Task of the risk manager is to classify and interpret relevant risk measures as per the need of the organization since it is not possible to list the full gamut of potential risks. Moreover, one template of risk classification cannot generalize risk management for all organizations.

If we consider BASEL II framework for non-financial firms, it distributes risk into three categories

1.  Operational risk (business risks, IT, business operations)
2.  Financial risk ( Interest rate, exchange rate, inflation, counterparty, insolvency)
3.  Market based risk.

Other risks which may be considered but not specified in BASEL II are Strategic risks (reputational, political, demographic) and Hazard risks (diseases, fire, theft, crime). So we can say that there is no exhaustive list of all the potential risks for organizations and it is only tailor made structure which is efficient.

Conclusion: Organizations sitting on the assumptions of risk management to be of only financial nature and treating them in piecemeal fashion are prone to risks of crisis in the long run. Holistic approach of risk is the need of latest and future generation of firms. Sooner or later they would be embracing firm-wide perspective of the risk management. Risk management will take new leaps and bounds in the coming future by treating risk management as one of the essential arm of any successful organization.

Thanks & Regards

PureValue Research Team

www.pvalueresearch.com