FAQs on Valuation Considerations When Valuing Distressed or Impaired Businesses
Valuation uncertainty is not to be confused with distressed or impaired businesses. Distressed or impaired businesses have unique characteristics impacting asset value; whereas, valuation uncertainty is concerned only with uncertainties that arise as part of the process of estimating value on a specific date.1 Distress may be a temporary operating characteristic of the subject company whereas impairment normally coincides with permanent adjustment.
COVID-19 and its market disruption is an example of a valuation uncertainty that is causing unprecedented impacts on the economy and industry. Input variables used as of a valuation date coinciding with an unprecedented matter may cause the valuation analyst to produce a conclusion of value that overcompensates for the impact of the uncertainty. This can have both negative and positive implications depending on the date of the valuation. The current pandemic and its impacts are an example of the “negative” while an example of “positive” impacts can be observed by analyzing the valuation of “dot com” companies prior to their market adjustments in the early 2000s. Valuation analysts should consider these phenomena in arriving at their conclusion of value as well as consider the temporary and permanent characteristics that impact their overall valuation conclusion.
This FAQ discusses questions for valuation analysts to consider and provides guidance on approaches valuation analysts may take, when performing valuations of companies that possess characteristics of distressed or impaired businesses as well as performing valuations in times of “positive” and “negative” economic uncertainty.
Valuation Considerations When Valuing Distressed or Impaired Businesses:2
- What are the differences between distressed and impaired companies?
- Impaired companies, like impaired assets, are those that reflect a reduction in the quality, durability, quantity and, thus, the value of an asset. Distressed companies are unable to meet, or are having difficulties, in paying their obligations (e.g. debt, operating expenses). Most impaired businesses have gone through a period of being distressed. The two are not mutually exclusive to one another.
- What are characteristics of a distressed business?
- A distressed business experiences periods of stagnant or declining revenues. Valuation analysts may compare the subject company to a peer group of companies in the same industry in order to determine if the cause of the distress is company specific or industry specific. For example, if the decline is from poor management then one needs to estimate the impact of replacing existing management with new management. However, if the industry is also suffering from the same decline then the analyst determines if this decline relates to an industry impairment.
- Margins have eroded primarily due to lower pricing in comparison to competitors.
- Subject company is liquidating assets to meet debt and expense obligations.
- Current assets, specifically cash, are being depleted more quickly than they were in preceding periods, even with adjustments for margins considered.
Failure to incorporate any of these characteristics into the valuation may result in over valuation of a subject company or asset.
- What adjustments can I make to incorporate the potential impact of distress?
- The primary adjustment to consider when evaluating a company’s increased default risk is to make an upward adjustment to the company specific risk premium when developing the discount rate. In addition, future growth rates and the terminal value, which may optimistically assume constant growth forever, may need to be adjusted for potential negative earnings. This adjustment can be done by decreasing growth rates for a short period of time in the discrete period cash flows, in the terminal value, or both.
- Using a comparable company approach can cause valuations of distressed companies to become skewed if comparing certain variables from the comparable companies (e.g., Revenues, EBITDA) without taking the appropriate steps to incorporate the impact of the distress. A valuation analyst can either (1) adjust the multiples to reflect samples of comparable companies that have similar characteristics of distress or (2) use a qualitative analysis to determine the appropriate discount to account for the decrease in value in comparison to healthy comparable operating companies.
- When speaking with clients and other professionals how can I elaborate on this business cycle issue?
- Valuation analysts may discuss the premises of value with management and communicate the differences in value produced from a going concern verses a liquidated value. Management also needs to understand where the business is within its lifecycle and comprehend the value of their company at points along this continuum. Helping clients or other professionals identify and understand common traits that may indicate distress or impairment may be incredibly important and helpful in times of uncertainty. A couple of common examples include: a) Companies in decline have underperforming assets which may be evidenced by market values falling below liquidation values; and b) Companies in distress or that have an impairment may also have lower return on equity(for example, existing assets may be worth more by liquidating than continuing operations).
- In the current economic environment with COVID-19 what are some items I need to consider?
When valuation analysts are preparing for an engagement that may be impacted by the COVID-19 pandemic the guidance in the AICPA’s Statement on Standards for Valuation Services , Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset (VS sec 100) identifies the requirements and guidance that members need to consider for each valuation engagement. For the current economic environment valuation analysts should make sure to appropriately consider the impact of both non-financial and financial information (VS sec 100, paragraph 27 and 29, respectively). Some COVID-19 specific examples might include:
- The economic conditions as of the valuation date.
- The ability of management to obtain economic relief and their plans to manage liquidity, assets and potential debt, while adjusting for differing conditions with their supply chain, customers and industry.
- The potential for companies to enter bankruptcy or a reorganization plan and the impact that such direct costs (i.e. attorneys, accounting, court, etc.) have on cash flows.
- Historical operating margins and the company’s balance sheet (i.e. solvency) to assess the future implications of a one-time, atypical event. The COVID-19 pandemic may have only short-term implications and strong companies may emerge stronger, while competitors with “heavy” debt obligations may need to close and/or liquidate assets. Strong companies and their management may consider this phenomenon an opportunity to strengthen their balance sheets and other assets (e.g., workforce, distribution channels). As stated by Aswath Damadoran in a recent blog post3, ““I think it still makes sense to look at growth, profitability and reinvesting, pre-crisis, to get a sense of how much punishment companies can take. In businesses that already had anemic revenue growth, low margins and poor investment efficiency, the effects of the crisis will be far more devastating than in businesses with higher growth, margins and efficient investment.”
- Consider the possibility the pandemic will produce an irreversible decline in either the relevant industry or for the client. Certain companies will not survive, and the valuation analyst needs to consider this when reviewing companies in certain industries. Damadoran states, “I looked at one factor that will determine survival risk, and that is the buffer that companies have on growth, profitability and reinvestment, with companies in higher margin businesses being more protected than companies in businesses with slim or negative margins. In this one, I look at the other factor that will determine survival and that is the debt burden on firms, since companies with higher debt burdens, other things remaining equal, will be more exposed to failure and distress than companies without those burdens.”4
- Is the company distressed (flat revenues, declining margins) or are the problems fixable? If the latter, consider running a valuation model accounting for changes to better operations and use a probability metric to determine value. Assess the likelihood of each model to determine your conclusion of value.
- If the problems are unable to be rectified, then the analyst needs to consider determining the value of existing assets in an orderly liquidation versus a forced liquidation. The premise of “going concern” may need to be removed or mentioned and possible unlikely. If the company has operating capacity to meet debt obligations and operating expenses for a period, then they may maximize asset value by offering these assets in an orderly liquidation as opposed to a fire sale.
- Consider use of valuation models to determine the current pandemic’s impact on short-term and long-term cash flows. Consider varying cash flow models and assign a ranking based upon likelihood, probability, etc. The uncertainty on the long-term impact of this market event is currently unknown. However, valuation analysts can rely on data from similar historical events to create models that adjust cash flows and risks for varying scenarios.
- If COVID-19 has impacted my client’s business after the valuation date but before I finalize my valuation report, how do I deal with that?
- VS sec 100 paragraph 43 identifies this as a subsequent event. Subsequent events are not required to be part of the valuation report; however, if a valuation analyst chooses to disclose them VS sec 100 provides clear guidance on how and what should be disclosed. A complementary ‘Subsequent Events Toolkit’ that can help practitioners navigate this topic in the current environment of uncertainty as well as in more stable economic and financial conditions. Go to Toolkit
“This one is a reminder to firms that debt, while making good times better for equity investors, makes bad times worse. For some of these firms, that debt will threaten their continued existence and result in liquidations, fire sales and distress. For others, it will create constraints for the near future on growth and investment, and change business plans. For firms that are lightly burdened, it may create opportunities, as they use their liquidity as a strategic weapon to fund acquisitions and to increase market share.”5
Authored by Josh Shilts, CPA/ABV/CFF/CGMA, CFE with contributions from Maureen Rutecki, CPA/ABV/CFF, ASA, MBA and Steve York, CPA/ABV/CEIV, ASA, CBA, CGMA
1 “Dealing with Market Uncertainty at times of market unrest”. March 2020, International Valuations Standards Council. A Letter from the IVSC’s Technical Standards Board.
2 Portions of this section were obtained from a review of Aswath Damadoran’s publication “Valuing Distressed and Declining Companies”. June 2009.
3 Musings on the Market, March 2020.