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

Every business faces risks. Every distressed business was once a healthy business. Valuations are forward-looking. So, in order to do a proper forward-looking valuation, how do you recognise early warning signs that the nature and magnitude of the risks are turning a healthy business into a distressed business? Some of the signs are objective, quantitative, financial: the Altman Z-Score Pro has good predictive capability over 1-3 years at a 75%-90% confidence level. Other signs are qualitative: new major competitors, management/workforce instability (culture problems), failed product initiatives, etc. The point is that as the valuer you need to be able to successfully see these coming and understand their valuation implications.

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.

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.

All methods should be assessed. A well-developed DCF will indicate if an asset approach might yield the highest value. If the company cannot generate sufficient return on assets then intangible value is less of a consideration and the asset approach might be more relevant.

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.

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.

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.

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.