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.