By: Cameron E. Cook, ASA, CIA, CDBV, AccuVal Associates, Inc.
Valuations of underperforming businesses have peeked in recent years. While the overall process of valuing financially distressed versus healthy companies is largely the same, some modifications are needed. Heightened focus on due diligence procedures, especially the source of financial projections, is essential.
When valuing a financially distressed business as a going concern, it is assumed the company will move forward under some plan of recovery rather than be shut down and liquidated. Under this going concern premise, the discounted cash flow (DCF) method of valuation is often relied upon.
The DCF method determines the present value of a company's projected cash flows using a discount rate that is appropriate for the risk of the company and its projections. It is typically relied upon for valuing financially distressed companies because historic performance is often negative and may not represent the future benefit of ownership. Further, distress is often difficult to take into consideration using the market approach. The DCF method provides flexibility and detail, incorporating any expected continued losses, unique expenses and return to profitability of the company as it progresses through its projected recovery.
Projections of the distressed company's performance are critical to the DCF method. Most often, projections used in a valuation analysis are prepared by management of the company. While management certainly is closest to the business and is vested in its success, projections still need to be reviewed, critiqued and assessed for reasonableness and risk for the DCF method to be applied effectively.
Following are 12 questions to ask during the preparation or examination of financial projections. For distressed companies, they will help management be better prepared for in-depth questioning during the due diligence process. For investors, these questions will improve understanding of risk, mitigate surprises and, ultimately, improve investments.
Understand the assumptions underlying the projections. Assumptions should be reasonable and well-supported. Make sure it is clear exactly how the distressed company will meet its projected revenue growth. Discuss whether projected operating profit margins are really obtainable.
The company's historic performance might not be a good benchmark of how the financially distressed company can perform in the future. Be careful of projections that simply "assume" the company will reach the same levels achieved in the past. Many companies peaked prior to the Great Recession and will have a much more difficult time attaining similar performance under current market conditions. For some businesses, returning to the performance level of the prior peak may take years; for some, it will never happen.
Studies have found that analysts who prepare projections and predict earnings more often overestimate than underestimate. This "positive bias" is common, particularly in down times when many companies simply assume they will be able to get back to where they once were. Management is expectedly optimistic. But projections need to fully consider pressures the market will apply to prevent the company from achieving projected performance targets.
Be sure the cause of financial distress is known, understood and addressed by the company. Sometimes the economy is blamed for business decline but other contributing factors such as a permanent shift in consumer preference or the strengthening of a competitor are overlooked. Those other factors might not go away as the economy or industry recovers. Make sure projections incorporate any changes the company needs to make in order to address the underlying causes of financial distress.
Distressed companies often have extra costs that relate to or stem from financial distress. These may include but are not limited to restructuring consultant or turnaround management fees, extra legal expenses from labor litigation, severance pay or expenses from employee terminations, extra accounting expenses due to stronger reporting requirements from banks and investors and even retention bonuses to retain key personnel. Similarly, litigation and settlement costs for outstanding warranty claims, environmental liabilities and other legal disputes should be properly factored into projections.
In an effort to conserve cash, it is common for distressed companies to defer capital expenditures for maintenance, replacement and new development. Projections should capture the full investment needed to return the company to the level of production assumed in the forecasts. Scrutinize these assumptions regarding capital expenditure requirements.
In a similar vein, a distressed company's plan of recovery might be to produce more of a particular new line of product or to sell more "commodity" or "standard" product, which may require increased production capacity. Further, projections often project production levels that go beyond the current capacity of the company. Make sure projections incorporate the expansion investment required to achieve those production levels or moderate production forecasts to fit current capacity constraints.
Labor, at all levels, is often reduced to a very lean level during periods of financial distress. Projections should take into account the full extent of additional production, sales and management personnel needed to support forecasted increases in production and sales. The addition of second shifts, additional sales and more management might be needed. Looking at historic or industry labor hours to production ratios might test the reasonableness of labor assumptions.
The additional investment in working capital needed to support the projected business operations needs to be included in the projected cash flows used in the DCF analysis. This can be challenging, particularly in poor economic times or distressed situations. In order to increase cash flow, a distressed company might try to accelerate accounts receivable or even factor them, sell down inventory to bare levels and at the same time stretch accounts payable. This temporarily increases cash flow but sacrifices working capital levels. These reduced levels of working capital are likely not sustainable and, during the recovery period, the company will need to invest in working capital to restore a more functional level. Be aware of projected working capital levels that are lower than historic working capital as a percent of sales. Assumptions regarding inventory turnover, accounts receivable collection rates and the willingness of suppliers to extend terms should be realistic.
Restructuring can take time, and working through legal challenges takes management resources away from operations. The length of time needed to establish a stable level of future performance is often longer than projected. Growth rates should be supported, and the recovery timeline should consider the diversion of key personnel to address recovery issues.
Net operating losses (NOLs) can affect the projected cash flow of a company working through financial distress. The company might be able to use NOLs to offset future income tax payments, resulting in enhanced future cash flows. But the availability of NOLs and their use are dependent on several factors. The extent that NOLs can provide benefit to the distressed company being valued needs to be taken into account in the projections accordingly. Question forecasts that show tax expenses projected at a constant tax rate.
Projections created a significant time before the valuation date may no longer accurately reflect the expected performance of the company as of the valuation date. For example, projections prepared at the beginning of the year may not be relevant after the economy has turned down and the company has slid into distress for six months. Further, there might be more than one set of projections. Perhaps the company considered best, worst and middle-of-the-road projections. Make sure that projections are timely and best represent the most likely performance of the distressed company.
These questions and others can provide insight and help assess the risks of projections used in the valuation process. The risk of the projections uncovered through this examination will help determine the appropriate discount rate applicable to the company. This match between the risk of the projections and the discount rate used is critical to an accurate valuation.
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