Introduction to Distressed Companies
A company is said to be in distress as and when it’s unable to meet its financial obligations or faces a significant cash crunch to its creditors due to some contingent events, business downturns, high operating expenses (mainly fixed cost), and/or inability to manage businesses changing scenarios. This causes troubles when financial analysts are formulating strategies of valuation for that said company.
Distress can be broadly categorized into economic and financial distress. Economic distress can be classified as financial uncertainties arising from contingent events, events such as supply deficits, natural calamities, and labor union strikes. Financial distress can be said to be a subset of economic distress considering not every time a company undergoes financial distress it is caused due to economic factors but by factors such as asset divestitures, lack of confidence in management, falling margins, etc.
Additionally, the inability to repay the debts or meet financial commitments does not reflect the company’s insolvency as the value of the company is tied to the assets owned by the company. The valuation of distressed assets allows the company to make a sound decision as to its operating activities whether it should continue its operations for the foreseeable future or shut down its operations minimizing its variable cost.
The approaches to the valuation of distressed assets are very stringent and based on economic principles of price equilibrium, anticipation of benefits, or substitution. The main valuation approaches that are to be discussed are as follows:
The market approach provides an indication of the value of distressed assets by comparing the asset with identical or comparable (that is similar) assets for which price information is available. The Market Approach Method comprises various valuation methods such as:
Comparable Transaction Method: This method is used when information regarding several transactions of a similar nature is available, and those transactions shall be carried out near the valuation date.
Guideline Publicly Traded Comparable Method When the distressed asset subjected to valuation is publicly traded and its comparable asset has a meaningful valuation, the above-pertaining method is used for deriving the value of the distressed asset.
The Income Approach valuation method values a distressed asset by discounting its future cash flows to its current value. Under the income approach, the value of an asset is determined by reference to the value of income, cash flow, or cost savings generated by the asset.
The various methods of valuation of distressed asset used in the Income Approach method comprises the following:
DCF Method: Values adistressed asset by discounting its forecasted future cash flows to its net present value.
Explicit Forecast Method: Mainly used if the distressed asset has a short life span as it involves a projection of the asset’s forecasted future cash flows.
The cost approach devises the value of a distressed asset on the mechanism that the buyer of the asset will not be able or willing to pay more than the amount which is incurred to acquire the asset of equal utility. Further, the valuation methods used in this approach comprise the following:
Replacement Cost Method: This method offers an equivalent utility indicating value by calculating the cost of a similar distressed asset.
Reproduction Cost Method: In this method, value is calculated by estimating the cost to recreate a replica of a distressed asset. Summation Method: This is a two-step method in which firstly the value of separate component parts is calculated and then the same is added to arrive at the value of the distressed asset.
XYZ Airlines is a distressed company that operates domestic and international flights across the world. The company has been severely affected by the COVID-19 pandemic, which has reduced the demand for air travel, disrupted the supply chain, and increased health and safety costs. The company has breached its debt covenants and is facing liquidity problems. The company’s lenders have hired a valuation expert to estimate the value of the company’s assets and liabilities, and to determine the recovery rate for each class of creditors.
The valuation expert collects the following information from various sources:
- The company has total assets of $10 billion, consisting of $1 billion in cash and equivalents, $4 billion in aircraft and equipment, $3 billion in intangible assets (such as brand name and landing rights), and $2 billion in other assets (such as inventory and receivables).
- The company has total liabilities of $15 billion, consisting of $5 billion in secured debt, $8 billion in unsecured debt, and $2 billion in trade payables and other current liabilities.
- The company’s revenue for the last fiscal year was $8 billion, with a gross margin of 20% and an operating margin of -5%. The industry average gross margin and operating margin are 25% and 10%, respectively.
- The company’s revenue is expected to recover gradually over the next five years, reaching $12 billion by year 5, as the pandemic subsides, and travel restrictions are lifted. The company’s gross margin is expected to improve to 22%, but its operating margin is expected to remain negative at -2%. The company’s capital expenditure is expected to be high, at 15% of revenue per year, as it needs to upgrade its fleet and comply with new regulations.
- The company’s weighted average cost of capital (WACC) is estimated to be 12%, based on its capital structure, risk profile, and market conditions. The WACC reflects the required return for both debt and equity investors.
The company’s terminal value is estimated to be $15 billion, based on a perpetual growth rate of 3% and a terminal WACC of 10%.
The valuation expert identifies a set of comparable companies that operate in the same industry as XYZ Airlines, have similar size, growth, profitability, and risk characteristics, and have recent market prices or transaction values available.
The valuation expert selects four multiples to value XYZ Airlines: enterprise value (EV) to revenue, EV to earnings before interest, taxes, depreciation, and amortization (EBITDA), EV to earnings before interest and taxes (EBIT), and EV to net assets. The valuation expert calculates the median multiple for each metric from the comparable companies and applies it to XYZ Airlines’ corresponding metric. The results are shown below:
Conclusion: The valuation expert takes the average of the four values as the market value of XYZ Airlines’ enterprise. The average value is $2 billion. To obtain the equity value, the valuation expert subtracts the total debt of $13 billion from the enterprise value. The equity value is -$11 billion, which implies that the equity holders have no recovery potential.
The valuation expert estimates the net realizable value of each asset category by applying appropriate discounts or premiums based on their liquidity, condition, marketability, and obsolescence. The results are shown below:
Conclusion: The valuation expert subtracts the total liabilities of $15 billion from the net realizable value of the assets to obtain the equity value. The equity value is -$8.8 billion, which implies that the equity holders have no recovery potential.
The valuation expert projects the free cash flow (FCF) of XYZ Airlines for the next five years, based on the revenue, margin, and capital expenditure assumptions. The FCF is calculated as EBIT*(1-tax rate) + depreciation – capital expenditures – change in net working capital. The valuation expert assumes a tax rate of 25% and a depreciation rate of 10% of aircraft and equipment.
The results are shown below:
Conclusion: The valuation expert discounts the FCFs to present value using the WACC of 12%. The present value of the FCFs is -$4.4 billion. The valuation expert adds the present value of the terminal value of $15 billion, discounted at the terminal WACC of 10%, to obtain the enterprise value. The enterprise value is $9.8 billion. To obtain the equity value, the valuation expert subtracts the total debt of $13 billion from the enterprise value. The equity value is -$3.2 billion, which implies that the equity holders have no recovery potential.
The valuation expert compares the three approaches and concludes that the income approach is the most reliable and relevant for valuing XYZ Airlines, as it reflects the company’s ability to generate cash flows from its operations and its risk profile. The market approach and the cost approach may not capture the company’s specific circumstances and challenges and may be influenced by market conditions and assumptions that are not applicable to XYZ Airlines.
The valuation expert reports that the enterprise value of XYZ Airlines is $9.8 billion and the equity value is -$3.2 billion, based on the income approach. This means that the company’s assets are worth less than its liabilities and that the equity holders have no recovery potential.