Valuation practitioners often are asked to appraise the operating business assets included in a bankruptcy estate. There are numerous reasons to conduct such appraisals, including the assessment of debt collateral values, the identification of asset spin-off opportunities, the consideration of debtor-in-possession financing and the evaluation of a proposed plan of reorganization. The typical operating business assets subject to appraisal include net working capital (receivables plus inventory less payables), real estate (land and buildings) and tangible personal property (machinery and equipment, office furniture and fixtures, etc.).

Valuation practitioners frequently appraise each of these categories of operating business assets discreetly, using the generally accepted asset valuation approaches—i.e., the cost, market and income approaches. Occasionally, valuation practitioners appraise all of the subject operating business assets collectively. This method is called the unit valuation concept. Under this concept, all of the operating business assets included in the bankruptcy estate are valued collectively as a single operating "unit."

Valuation methods under the unit valuation concept include the direct capitalization method, the yield capitalization method and the stock and debt method. Some of these unit valuation methods directly extract empirical pricing data from the capital markets (i.e., the markets for publicly traded securities).

Valuation practitioners generally recognize that there is a value increment associated with the liquidity of publicly traded security prices compared with the illiquidity of most operating business assets —i.e., tangible personal property and real estate. Accordingly, a valuation adjustment (i.e., a discount) may be appropriate when using capital market data (i.e., stock prices, stock pricing multiples and direct capitalization rates) to value operating business assets for bankruptcy and reorganization purposes.

In addition to the above-mentioned illiquidity discount, there are at least 10 other analytical problems associated with the direct use of capital market data in both (1) the direct capitalization method and (2) the stock and debt method of appraising operating business assets (i.e., tangible personal property and real estate) for bankruptcy purposes. A summary of these additional "top 10" analytical problems is presented below.

Top 10 Analytical Problems

1) Stock prices are always forward-looking. They are influenced by investors' expectations of future income and future assets. Therefore, stock prices impound investors' expectations of the income from future mergers, acquisitions and capital expenditures—income that has not been earned as of the valuation date from the operating business assets (both tangible and intangible) that do not yet even exist on the valuation date.

2) Stock prices are substantially variable and sometimes erratic in the short term. Accordingly, they fluctuate to a much greater extent than do the values of the operating business assets included in the bankruptcy estate.

3) Stock prices fluctuate as a result of numerous factors that are not necessarily related to the income-producing potential of the underlying operating business assets. In fact, stock prices do not always fluctuate in direct proportion to the income, revenues or asset values of the underlying operating business asset property.

4) Stock prices are often influenced by macroeconomic factors that are fundamentally unrelated to the operating business property included in the bankruptcy estate. These macroeconomic factors may even relate to events that occur in another country (e.g., war breaking out in the Middle East).

5) Stock prices are often influenced by industry economic factors that do not specifically relate to the company or to the operating business assets included in the bankruptcy estate. For example, stock prices of all companies in an industry are often affected when there are mergers in that industry. In fact, stock prices are often materially affected by investors' expectations of possible future mergers in an industry (even when the mergers may not affect the subject company or the subject operating business property).

6) Stock prices include investors' perceptions of the value of all of the operating assets of the subject company. Therefore, stock prices include the value of (1) tangible personal property, (2) real estate, (3) discrete intangible assets such as the value of contracts, computer software, trademarks, assembled workforce, etc. and (4) general intangible value in the nature of goodwill, including the present value of future income expected to be generated by future operating assets (both tangible and intangible assets) not yet in existence as of the property valuation date.

7) Stock prices are influenced by the supply and demand of investment securities. In other words, as investors' demand for securities increases—due to the current trends of the substantial amount of investments in mutual funds, 401(k) and other pension-related plans, etc.—stock prices tend to increase. Of course, this level of investors' current demand for investment securities does not affect the supply and demand of the operating business property included in the bankruptcy estate.

8) Stock prices are influenced by the level of investment diversification in investors' portfolios. As investors diversify their investment portfolios (through the means of mutual funds or through multiple security holdings), they minimize the non-systematic form of investment risk. Of course, the subject company cannot similarly diversify its holdings of the operating business properties included in the bankruptcy estate.

9) In cases where the subject company—or the selected guideline publicly traded companies—operates in multiple industries, then the stock prices may be disproportionately influenced by investors' perceptions of the value of industries not included on a unitary basis (as compared to the industries included on a unitary basis). This is particularly true when neither the subject company nor the guideline publicly traded companies are "pure play" companies. In these cases, the guideline publicly traded companies may not be truly "comparable" to the subject operating business.

10) The use of stock prices, stock pricing multiples and direct capitalization rates tends to overstate the value indications of the more successful companies in an industry. This is true if the selected stock prices, stock pricing multiples, and direct capitalization rates are based on central tendencies (e.g., means or medians) of the subject industry data. This observation is especially true if the subject industry data include companies that have poor financial performance.

Summary and Conclusion

Even after adjusting the capital market data for the fundamental differences in liquidity between stock prices and operating business assets, capital market-based valuation methods may not directly provide reliable value indications for the operating business assets (e.g., the tangible personal property and real estate) included in the bankruptcy estate. This is because valuation methods that directly use capital market data—i.e., the direct capitalization method and the stock and debt method—are still afflicted by the "top 10" additional analytical problems discussed above.