What are the key differences between valuing a distressed business and a healthy business?

Acquiring a distressed business is not for the faint hearted. You'll have to have a good understanding of what levers you can pull to turn the business around, and a clear plan for restructuring that will put the business back on a path to profitability. There are big opportunities for a good deal in acquiring a distressed businesses, but also significant risks.

In evaluating a distressed business versus a healthy one, the nuances in financial metrics and risk factors become quite pronounced. In the case of a distressed business, the valuation process demands a deeper dive into potential liabilities, restructuring costs, and the impact of market sentiment on future cash flows. Conversely, a healthy business typically presents a more straightforward assessment, focusing on growth potential, stable cash flows, and solid operational performance. Understanding these disparities is crucial for making informed investment decisions and implementing effective turnaround strategies where needed.

Valuation of distressed business basically evaluates the "Going Concern" assumption from multiple POVs in the case of the DCF Valuation Method, which is appropriate for healthy businesses. It is also possible to value a distressed business with the Net Asset Value method, which is the most appropriate method for distressed businesses.

Just remember that a distressed entity can't operate with conventional means (i.e., financing) and will probably need a longer time-frame to pay back any working funds advance to it and/or extend re-payment terms to its own vendors. That being said, the liabilities should be adjusted before the NTA is calculated. Then the cash flow forecast/budget should also be finessed to match the new payment terms. There is still a cost of floating money (or not paying) up to the A/P limits. A distressed company has no true market value but only a cash flow (or net tangible asset) value.

In case an entity is unable to meet its debt obligations, it is considered a distressed entity. Some simple ratios, such as the interest coverage ratio, can indicate if the entity is in distress.

Fluxo de Caixa Negócio Saudável: Geralmente possui um fluxo de caixa estável e previsível, com receitas consistentes e custos controlados. Negócio em Dificuldades: Pode apresentar fluxo de caixa irregular ou negativo devido a problemas operacionais, queda nas vendas ou aumento dos custos. Análise de Sensibilidade Negócio Saudável: A análise de sensibilidade pode ser mais estável, com variações menores nos resultados projetados. Negócio em Dificuldades: A análise de sensibilidade pode ser mais volátil, com variações significativas nos resultados devido à sensibilidade a mudanças nas condições operacionais e financeiras.

There's an element of option when valuing a distressed business as compared to a healthy business! So, the risks and rewards, both are high!

Valuing a distressed business differs greatly from valuing a healthy one due to factors like cash flow volatility, higher risk, and uncertain future performance. A healthy business, with stable cash flows, can use standard valuation methods like Discounted Cash Flow (DCF), while distressed businesses require adjustments for restructuring or potential liquidation. Debt levels, intangible assets, and management effectiveness also play key roles. Distressed businesses often attract niche buyers looking for discounts, whereas healthy businesses appeal to a broader pool. In both cases, valuers must account for risks and market conditions to determine fair value.

To value a distressed business, it is crucial to understand if the business has the ability to pivot its current state and generate potential income in the years to come. If yes, then the business can be valued through DCF methodology contingent to the fact that there should be a high discounting factor to compensate the stipulated risk. On the contrary, if the business is not expected to generate any revenue, then DCF is not a viable methodology to value the business. In this case, business should be valued through liquidation valuation approach. Under this approach, the business is valued primarily based on the value that the shareholders will receive after liquidating the assets and meeting/ paying-off all the liabilities.

A healthy business generates returns whose discounted present value is greater than that of their assets alone. Conversely, a distressed business does not generate such returns. That fundamental difference determines the valuation method to be applied. A healthy business is valued on a forward-looking basis to capture the value of its expected returns, usually an earnings-based approach (discounted or capitalised cash flow). Conversely, in a distressed business with operational/financial problems and a high(er) risk of not surviving into the future, the present value of future returns is typically less than the value of the assets so the business is valued using an asset-based method.

Valuation from different methods should be derived as per appropriate data and assumptions, instead of discarding any method outright - especially the DCF, CoCo and NAV. Valuation of distressed business has to take into account the additional investments that will be required to revive the business, if the valuation is for the purpose of Business Restructuring or Take-over Distress Sale. This additional investment is considered over and above the buying price of the business or immediate settlement of liabilities, if needed. Similarly, CoCo and NAV methods provide appropriate views on the business's valuation. Accordingly, overall financial metrics are calculated and analyzed before decision making.

A distressed business can be valued in two steps. First, the business should be valued as a going concern. Second, option pricing would be used to allocate debt value, with the remaining equity value representing the residual value on a distressed basis.

How do you see the story unfolding over a period of time and what are the types of assets a company possess that will create the value for them? Accordingly choose your valuation approach!

Understanding the nuances between valuing distressed businesses versus healthy ones is pivotal in navigating diverse financial landscapes. In distressed scenarios, factors like operational inefficiencies, impending liabilities, and market perceptions heavily influence valuation dynamics, requiring a keen eye for risk assessment and mitigation. Conversely, valuing a healthy business entails a focus on growth prospects, stable cash flows, and robust operational frameworks, where traditional valuation methodologies often suffice. Adapting valuation strategies to the unique circumstances of each scenario is paramount for informed decision-making and maximizing stakeholder value.

Distressed businesses are frequently valued using liquidation value or fire sale assumptions, rather than going concern valuations. Healthy businesses are commonly valued based on future earnings potential and market comparables. For distressed businesses, emphasis is placed on short-term viability and potential recovery scenarios. Healthy businesses often utilize discounted cash flow (DCF) models focusing on long-term growth. Asset-based valuations are more prevalent in distressed business scenarios to assess recovery amounts.

Because valuations are as much art as science, they inherently involve margins of error which at times can be substantial. One common method to determine the value of the business under different possible future situations is 'scenario analysis': this is the classic best-, expected- and worst-case approach. If the business' circumstances are complex and there is a myriad of possible future situations, you could use Monte Carlo Simulation to produce a probability-based range of valuations that encompasses the full range of future scenarios. The appeal of the Monte Carlo technique is that it produces an intuitive visual distribution of the possibilities, to which you as the valuer can apply your expertise to choose the most applicable.

If the valuer believes that the company is not likely to survive, valuation must be done using the cost approach and individual assets’ realisable value (liquidation value) should be assessed assuming that the company will be liquidated. In the likelihood or survival, projected cash flows may be estimated to value as per DCF method. Suitable probabilities may be applied for success / default. Overall, Value = Going concern value x probability of survival + Liquidation Value x Probability of failure

Each method of Valuation has a suitable technique to be considered while doing the calculations. For e.g. 1. DCF Method for distressed businesses needs to consider higher discount rates for future cashflows, however long that may be. This is to ensure that the investment can be recovered at the earliest. 2. CoCo method has to consider multiples of only other distressed businesses and adjust for the level of distress. 3. For NAV Method, the bargaining power of buyers needs to be considered in distress sale arrangements. The assets will always be sold at a discount which should be assessed.

You have to be as pragmatic as possible and be clear on the risk involved. Cutting costs is always easier than growing market share, so don't be fooled into thinking that it's just a case of doing a bit more sales and marketing. As a buyer of a distressed business you have significant leverage when it comes to putting a deal together, but that's only a benefit if you fully understand the risks.

Scenario analysis is critical in distressed valuations to account for various potential outcomes. Healthy businesses benefit from stable, predictable financial projections, making traditional models like DCF more applicable. Real options valuation may be used for distressed businesses to evaluate decisions like restructuring or liquidation. Healthy businesses often use peer group analysis to gauge market value. Adjustments for financial distress costs, such as legal and administrative expenses, are often necessary in distressed valuations.

Analysts often focus more on tangible assets when valuing a distressed business. For instance, when General Motors filed for bankruptcy in 2009, its factories, equipment, and patents were critical components of its valuation. Sometimes, analysts might create multiple scenarios—optimistic, pessimistic, and most likely—to account for uncertainty. During the COVID-19 pandemic, many companies had to reassess their valuations based on varying recovery timelines.

Valuing a business is a mixture of art and science. There is always an 'art' element to the process because the valuer's decisions concerning applicable assumptions in the calculation reflect the valuer's personal experience, learning and (often unrecognised) biases. The 'science' is in the numbers. The old saying is that they don't lie, but that's not really true; the numbers depend on the availability and quality of data (which may be incomplete or unpredictable) and the valuer's (subjective) judgment about what data to use and how to use it. You can mitigate these issues by creating more than one valuation using multiple methods and techniques and then averaging the results.

Market research, careful analysis of revival strategy, discount rates for cashflows and asset values, comparable multiples, reasonable judgement, scenario and sensitivity analysis are some of the tools in the artillery of the Analyst.

Estimating the true value of assets in distress can be complicated due to potential rapid depreciation. Predicting cash flows in distressed businesses is more uncertain and risky. Determining the discount rate for a distressed business can be challenging due to higher business risks. Access to capital is usually restricted for distressed businesses, affecting their valuation. Market conditions can significantly sway the valuation of a distressed business due to sensitivity to external pressures.

One of the biggest challenges of valuing a 'distressed' business is that you know any investor or buyer will apply some kind of discount in their mind for anything distressed that they see. There is no science to this. It is simply opinion. It's more about what the company is worth to them in its distressed state than simply what the numbers say. And this is a spectrum, not a clearly stated fact. In an odd way, you could value it lower or higher depending on who the prospective buyer is, and that itself presents quite a challenge.

Valuations intended for corporate restructuring purposes have many strategically important applications, particularly with respect to maximising shareholder value if the business may be more valuable in pieces than as a whole. For example, a buyer may want to acquire your operations, but not your real estate holdings. A valuation exercise can identify ways to make your company more attractive to potential buyers - for instance, by putting real estate assets in a holding company that can be sold or spun off into a separate publicly-traded subsidiary.

Such applications of valuation decide the type of metrics required as an output of the whole Valuation exercise. These outputs will decide the course of action for various stakeholders. If the government needs to intervene, if an arbitrator and liquidator needs to be appointed, if a strategic partner is required for revival and so on and so forth.

Distressed business valuations are often used in bankruptcy proceedings, turnaround strategies, and emergency asset sales. Healthy business valuations are typically used for standard mergers, acquisitions, and raising capital. Valuations of distressed businesses may be required more frequently to monitor financial health and compliance with covenants. Healthy businesses might use valuation to inform strategic planning and shareholder communications. Distressed valuations are crucial for negotiating with creditors and potential investors.

Some investors specialise in distressed assets, hoping for a turnaround. Warren Buffett's investment in Bank of America during the 2008 financial crisis is an example of capitalising on distressed valuations.

Valuations of seriously distressed companies that are in or near bankruptcy may have surprisingly positive implications. For example, a business that is poised to file for a Chapter 11 reorganisation typically needs debtor-in-possession financing to continue its operations while the financial restructuring is carried out. This requires a bifurcated valuation; one part values the business and its assets on a liquidation basis for the purposes of the lender who provides the secured DIP funding in case the restructuring isn't successful, the other values the business as a going-concern for the purposes of the inter-creditor negotiations to determine who gets how much equity/value in the business if the restructuring is successful.

Ativos e Passivos Negócio Saudável: Costuma ter ativos valiosos e passivos bem controlados, com uma boa relação entre os dois. Negócio em Dificuldades: Pode ter ativos desvalorizados e passivos em crescimento, com uma relação desequilibrada que pode indicar insolvência.

Crescimento Negócio Saudável: Tende a ter taxas de crescimento consistentes e positivas, investindo em novos projetos e expansões. Negócio em Dificuldades: Pode estar enfrentando uma estagnação ou declínio nas vendas e operações, com pouca capacidade de investir em crescimento.

Impact of Economic Environment Access to Financing Options Stakeholder Interests Legal and Regulatory Implications Potential for Recovery or Growth Timing of Valuation Specialist Valuation Expertise Needed Sensitivity Analysis Importance Historical Data Limitations Influence of Non-operating Assets

Depending on how distressed the business is, you may consider that it is only valued by the assets within it, using an assets-based approach. The other thing to think about here is that if this is the case, a buyer may not care to purchase all of the assets, so you may need to find multiple buyers.

Operating Income vs Non Operating Income If the organisation is inflating profits from Non operating income, it means the company is having trouble generating revenues from their core operations. Which can show differentiate healthy from distressed companies.

When valuing distressed businesses, it's crucial to consider not just the financial metrics but also the underlying causes of distress, such as market conditions or operational inefficiencies. Unlike healthy businesses, which can often be valued using traditional methods like discounted cash flow (DCF) or comparable company analysis, distressed businesses may require a more nuanced approach, such as asset-based valuation or liquidation analysis. The potential for turnaround strategies can significantly influence the valuation, highlighting the importance of understanding the business's operational context and the management team's capability to implement change.