One of the most frequently debated yet least understood issues in business and law is the value of a firm. The process of valuing a firm is even more complex and less understood when one adds to the equation the fact that the firm is financially distressed or has even already filed for bankruptcy.

The initial issue that should be addressed is whether the firm's value should be derived as a liquidation value or a going-concern value. Generally, the appropriate method depends on the facts relevant to each specific case. For example, if creditors value a firm for the purpose of deciding whether to support a reorganization, or alternatively to pressure for its liquidation, valuations based on both a liquidation assumption and a going-concern assumption are typically derived.

Liquidation value reflects the firm's expected proceeds, assuming the business is discontinued and the assets are sold off piecemeal. The literature distinguishes between orderly liquidation (assets are sold over a reasonable time period) and forced liquidation (assets are sold quickly, often at an auction sale). Usually, a liquidation valuation can be estimated with more precision than a financially distressed enterprise valued as a going-concern. The focus of this article is the valuation of such a distressed company as a going-concern. Obtaining the fair market value of such a firm based on a going-concern assumption typically requires the use of several key methodologies.

Publicly Traded Comparables

Valuation experts often use a multiple based on the firm's earnings before interest and taxes (EBIT), frequently referred to as operating income. First, a group of publicly traded comparable firms is identified and, based on that group, a most representative figure for the ratio of enterprise value-to-operating income is derived. The enterprise value is simply the sum of the firm's equity and its debt. Once this representative multiple has been obtained, the operating income of the firm being valued is multiplied by the multiple to derive the firm's enterprise value. Then to obtain the firm's equity, its debt is subtracted from the enterprise value. Similarly, experts often use other multiples, such as earnings before interest, taxes, depreciation and amortization (EBITDA), often referred to as operating cash flow. While the method of comparables is extremely useful when applied appropriately, it is often impossible to apply it to a financially distressed firm, particularly when the firm's operating income and operating cash flow are negative, or even positive but unusually small. In such cases, experts often tend to rely on a sales-based multiple. Unfortunately, while sales go hand-in-hand with long-term profitability, the revenue multiple is less useful than the profitability- and cash flow-based multiples. One way to overcome the negative EBIT and EBITDA limitation is to value the firm at some future point in time (when the operating income and operating cash flow are expected to be positive) and, if necessary, compute the present value of this figure discounted to the time of the desired valuation date.

One might also contemplate using distressed comparables. In general, based on our experience, the financial ratios of financially distressed firms often have an inappropriate sign, are unstable, and are subject to sharp variations over a short time period. Thus, they typically should not be relied upon for valuation.

M&A Transactions

Valuation experts often use information from mergers and acquisition (M&A) transactions involving firms comparable to the one being valued. Similar to the valuation methodology based on publicly traded comparables, the idea is to find a representative multiple based on the M&A targets and to then apply the multiple to the subject firm. However, in the case of distressed companies, this methodology suffers from the same limitations as the comparable company analysis. Specifically, a financially distressed firm often has a figure for net earnings, operating income, or operating cash flow that is not meaningful (i.e., negative, positive but very small, or extremely unstable).

One might contemplate using M&A transactions involving similarly distressed companies. However, in addition to the previously discussed limitation of a lack of meaningful profitability measures, there is also the risk of having a wrong measure of purchase price. For example, recently we reviewed the acquisition of a privately held firm that had been acquired by a publicly traded firm. A careful review of the terms revealed that the CEO (and founder) of the selling company was granted options in the acquirer's stock with certain provisions, and was also awarded a contract for long-term employment. For a relatively small M&A transaction, adding the value of the options and the employment contract has the potential of changing the actual purchase price and changing the acquisition-related multiples drastically as a result. In addition, while elements such as options and employment contracts play an important role in numerous transactions, they are even more likely to be of increased importance in M&A transactions involving distressed targets.

Discounted Cash Flow Methodology

Given that each distressed company has its own unique circumstances, and certain of the other valuation methodologies might potentially be limited, the relative importance of the discounted cash flow (DCF) methodology is increased. Several issues should be addressed, including the nature of the projected cash flows and the cost of capital and its components (the cost of equity and the cost of debt). The projected cash flows are clearly crucial for the valuation. Naturally, management is the source of the initial set of projected cash flows, and the valuation experts, often assessing their reasonableness, will potentially adjust them appropriately. In the case of a financially distressed (or already bankrupt) company, the situation is more complicated. There is the possibility that the cash flows are consistently biased. For example, in a recent article entitled "After Bankruptcy: Can Ugly Ducklings Turn into Swans?" (Financial Analyst Journal, May/June 1998), we presented the results of our research on financial and operational projections provided to the bankruptcy court by companies prior to their emergence from bankruptcy. The results suggest that the projections are frequently (and often greatly) overstated. The relevance of these results to valuation of financially distressed firms is clear: management is obviously interested in getting the "green light," enabling it to keep operating the business. As a result, the potential for a projection bias is clear. Nevertheless, it is our experience that management often knows the firm and its industry better than its advisors. In sum, while valuation experts' judgement and evaluation of the projected cash flows' reasonableness is always required, in the case of a financially distressed firm, verification or reassurance of the cash flow quality is generally warranted.

Another important element of the DCF valuation methodology is the cost of capital, which is used for discounting the projected cash flows. Obviously, once the news that the company is financially distressed is out in the marketplace, its cost of debt increases significantly. If the company does not have publicly traded debt instruments, the valuation expert might analyze bonds of similarly distressed companies and derive their yield-to-maturity as a benchmark for the cost of debt. Similarly, the cost of equity of the financially distressed company also increases along with the news of its difficulties. The traditional finance literature asserts that the cost of equity is generally higher than the cost of debt. It makes sense; shareholders are last in line in the case of liquidation. However, it is important to realize that as the company becomes increasingly distressed, the costs of debt and equity are both high, with the gap between the two effectively decreasing. In other words, the debt of an extremely high-risk company starts resembling equity. Moreover, certain frameworks often used for deriving the cost of equity might potentially be of limited use in the case of a financially distressed company. An example for such a framework is the measure of market risk (often referred to as beta or systematic risk). Ordinarily, this measure assesses the volatility of the firm relative to the overall market volatility. Clearly, under normal circumstances, a significant proportion of the volatility in the value of a company is driven by economy-wide factors. However, once a company is distressed, it has a momentum of its own only loosely related to market volatility, even though it might well be distressed as a result of a recession. Therefore, the focus might well shift from the traditional measure of market risk to the total risk facing the firm.

In sum, while a valuation of a company is generally complex, valuing a distressed company is further complicated by these and other additional unique considerations.