Valuing Firms in Distress


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1 Valuig Firms i Distress Aswath Damodara Aswath Damodara 1
2 The Goig Cocer Assumptio Traditioal valuatio techiques are built o the assumptio of a goig cocer, I.e., a firm that has cotiuig operatios ad there is o sigificat threat to these operatios. I discouted cashflow valuatio, this goig cocer assumptio fids its place most promietly i the termial value calculatio, which usually is based upo a ifiite life ad evergrowig cashflows. I relative valuatio, this goig cocer assumptio ofte shows up implicitly because a firm is valued based upo how other firms  most of which are healthy  are priced by the market today. Whe there is a sigificat likelihood that a firm will ot survive the immediate future (ext few years), traditioal valuatio models may yield a overoptimistic estimate of value. Aswath Damodara 2
3 Why distress matters Some firms are clearly exposed to possible distress, though the source of the distress may vary across firms. For some firms, it is too much debt that creates the potetial for failure to make debt paymets ad its cosequeces (bakruptcy, liquidatio, reorgaizatio) For other firms, distress may arise from the iability to meet operatig expeses. Whe distress occurs, the firm s life is termiated leadig to a potetial loss of all cashflows beyod that poit i time. I a DCF valuatio, distress ca essetially trucate the cashflows well before you reach irvaa (termial value). A multiple based upo comparable firms may be set higher for firms that have cotiuig earigs tha for oe where there is a sigificat chace that these earigs will ed (as a cosequece of bakruptcy). Aswath Damodara 3
4 The Purist DCF Defese: You do ot eed to cosider distress i valuatio If we assume that there is urestricted access to capital, o firm that is worth more as a goig cocer will ever be forced ito liquidatio. Respose: But access to capital is ot urestricted, especially for firms that are viewed as troubled ad i depressed fiacial markets. The firms we value are large marketcap firms that are traded o major exchages. The chaces of these firms defaultig is miimal Respose: Ero ad Kmart. Firms that default will be able to sell their assets (both iplace ad growth opportuities) for a fair market value, which should be equal to the expected operatig cashflows o these assets. Respose: Ulikely, eve for assetsiplace, because of the eed to liquidate quickly. Aswath Damodara 4
5 The Adapted DCF Defese: It is already i the valuatio The expected cashflows ca be adjusted to reflect the likelihood of distress. For firms with a sigificat likelihood of distress, the expected cashflows should be much lower. Respose: Easier said tha doe. Most DCF valuatios do ot cosider the likelihood i ay systematic way. Eve if it is doe, you are implicitly assumig that i the evet of distress, the distress sale proceeds will be equal to the preset value of the expected cash flows. The discout rate (costs of equity ad capital) ca be adjusted for the likelihood of distress. I particular, the beta (or betas) used to estimate the cost of equity ca be estimated usig the updated debt to equity ratio, ad the cost of debt ca be icreased to reflect the curret default risk of the firm. Respose: This adjusts for the additioal volatility i the cashflows but ot for the trucatio of the cashflows. Aswath Damodara 5
6 Dealig with Distress i DCF Valuatio Simulatios: You ca use probability distributios for the iputs ito DCF valuatio, ru simulatios ad allow for the possibility that a strig of egative outcomes ca push the firm ito distress. Modified Discouted Cashflow Valuatio: You ca use probability distributios to estimate expected cashflows that reflect the likelihood of distress. Goig cocer DCF value with adjustmet for distress: You ca value the distressed firm o the assumptio that the firm will be a goig cocer, ad the adjust for the probability of distress ad its cosequeces. Adjusted Preset Value: You ca value the firm as a ulevered firm ad the cosider both the beefits (tax) ad costs (bakruptcy) of debt. Aswath Damodara 6
7 I. Mote Carlo Simulatios Prelimiary Step: Defie the circumstaces uder which you would expect a firm to be pushed ito distres. Step 1: Choose the variables i the DCF valuatio that you wat estimate probability distributios o. Steps 2 & 3: Defie the distributios (type ad parameters) for each of these variables. Step 4: Ru a simulatio, where you draw oe outcome from each distributio ad compute the value of the firm. If the firm hits the distress coditios, value it as a distressed firm. Step 5: Repeat step 4 as may times as you ca. Step 6: Estimate the expected value across repeated simulatios. Aswath Damodara 7
8 II. Modified Discouted Cashflow Valuatio If you ca come up with probability distributios for the cashflows (across all possible outcomes), you ca estimate the expected cash flow i each period. This expected cashflow should reflect the likelihood of default. I cojuctio with these cashflow estimates, you should estimate the discout rates by Usig bottomup betas ad updated debt to equity ratios (rather tha historical or regressio betas) to estimate the cost of equity Usig updated measures of the default risk of the firm to estimate the cost of debt. If you are uable to estimate the etire distributio, you ca at least estimate the probability of distress i each period ad use as the expected cashflow: Expected cashflow t = Cash flow t * (1  Probability of distress t ) Aswath Damodara 8
9 III. DCF Valuatio + Distress Value A DCF valuatio values a firm as a goig cocer. If there is a sigificat likelihood of the firm failig before it reaches stable growth ad if the assets will the be sold for a value less tha the preset value of the expected cashflows (a distress sale value), DCF valuatios will uderstate the value of the firm. Value of Equity= DCF value of equity (1  Probability of distress) + Distress sale value of equity (Probability of distress) Aswath Damodara 9
10 Step 1: Value the firm as a goig cocer You ca value a firm as a goig cocer, by lookig at the expected cashflows it will have if it follows the path back to fiacial health. The costs of equity ad capital will also reflect this path. I particular, as the firm becomes healthier, the debt ratio (which is high at the time of the distress) will coverge to more ormal levels. This, i tur, will lead to lower costs of equity ad debt. Most discouted cashflow valuatios, i my view, are implicitly goig cocer valuatios. Aswath Damodara 10
11 NOL: 2,076m Curret Reveue $ 3,804 EBIT 1895m Value of Op Assets $ 5,530 + Cash & Noop $ 2,260 = Value of Firm $ 7,790  Value of Debt $ 4,923 = Value of Equity  Equity Optios $ 2867 $ 14 Value per share $ 3.22 Curret Margi: % Reveue Growth: 13.33% Cap ex growth slows ad et cap ex decreases EBITDA/Sales > 30% Stable Reveue Growth: 5% Stable Growth Stable EBITDA/ Sales 30% Termial Value= 677( ) =$ 28,683 Reveues $3,804 $5,326 $6,923 $8,308 $9,139 $10,053 $11,058 $11,942 $12,659 $13,292 EBITDA ($95) $ 0 $346 $831 $1,371 $1,809 $2,322 $2,508 $3,038 $3,589 EBIT ($1,675) ($1,738) ($1,565) ($1,272) $320 $1,074 $1,550 $1,697 $2,186 $2,694 EBIT (1t) ($1,675) ($1,738) ($1,565) ($1,272) $320 $1,074 $1,550 $1,697 $2,186 $2,276 + Depreciatio $1,580 $1,738 $1,911 $2,102 $1,051 $736 $773 $811 $852 $894  Cap Ex $3,431 $1,716 $1,201 $1,261 $1,324 $1,390 $1,460 $1,533 $1,609 $1,690  Chg WC $ 0 $46 $48 $42 $25 $27 $30 $27 $21 $19 FCFF ($3,526) ($1,761) ($903) ($472) 4 $22 5 $392 6 $832 7 $949 8 $1,407 $1, Beta Cost of Equity 16.80% 16.80% 16.80% 16.80% 16.80% 15.20% 13.60% 12.00% 10.40% 8.80% Cost of Debt 12.80% 12.80% 12.80% 12.80% 12.80% 11.84% 10.88% 9.92% 8.96% 6.76% Debt Ratio 74.91% 74.91% 74.91% 74.91% 74.91% 67.93% 60.95% 53.96% 46.98% 40.00% Cost of Capital 13.80% 13.80% 13.80% 13.80% 13.80% 12.92% 11.94% 10.88% 9.72% 7.98% Stable ROC=7.36% Reivest 67.93% Term. Year $13,902 $ 4,187 $ 3,248 $ 2,111 $ 939 $ 2,353 $ 20 $ 677 Forever Cost of Equity 16.80% Cost of Debt 4.8%+8.0%=12.8% Tax rate = 0% > 35% Weights Debt= 74.91% > 40% Riskfree Rate: T. Bod rate = 4.8% + Beta 3.00> 1.10 X Risk Premium 4% Global Crossig November 2001 Stock price = $1.86 Iteret/ Retail Operatig Leverage Curret D/E: 441% Base Equity Premium Coutry Risk Premium Aswath Damodara 11
12 Step 2: Estimate the probability of distress We eed to estimate a cumulative probability of distress over the lifetime of the DCF aalysis  ofte 10 years. There are three ways i which we ca estimate the probability of distress: Use the bod ratig to estimate the cumulative probability of distress over 10 years Estimate the probability of distress with a probit Estimate the probability of distress by lookig at market value of bods. Aswath Damodara 12
13 a. Bod Ratig as idicator of probability of distress Ratig Cumulative probability of distress 5 years 10 years AAA 0.03% 0.03% AA 0.18% 0.25% A+ 0.19% 0.40% A 0.20% 0.56% A 1.35% 2.42% BBB 2.50% 4.27% BB 9.27% 16.89% B % 24.82% B 24.04% 32.75% B % 42.12% CCC 39.15% 51.38% CC 48.22% 60.40% C % 69.41% C 69.65% 77.44% C % 87.16% Aswath Damodara 13
14 b. Bod Price to estimate probability of distress Global Crossig has a 12% coupo bod with 8 years to maturity tradig at $ 653. To estimate the probability of default (with a treasury bod rate of 5% used as the riskfree rate): t= 8 120(1 p 653 = Distress ) t Â (1 p Distress )8 (1.05) t (1.05) N t=1 Solvig for the probability of bakruptcy, we get With a 10year bod, it is a process of trial ad error to estimate this value. The solver fuctio i excel accomplishes the same i far less time. p Distress = Aual probability of default = 13.53% To estimate the cumulative probability of distress over 10 years: Cumulative probability of survivig 10 years = ( ) 10 = 23.37% Cumulative probability of distress over 10 years = =.7663 or 76.63% Aswath Damodara 14
15 c. Usig Statistical Techiques The fact that hudreds of firms go bakrupt every year provides us with a rich database that ca be mied to aswer both why bakruptcy occurs ad how to predict the likelihood of future bakruptcy. I a probit, we begi with the same data that was used i liear discrimiat aalysis, a sample of firms that survived a specific period ad firms that did ot. We develop a idicator variable, that takes o a value of zero or oe, as follows: Distress Dummy = 0 for ay firm that survived the period = 1 for ay firm that wet bakrupt durig the period We the cosider iformatio that would have bee available at the begiig of the period. For istace, we could look at the debt to capital ratios ad operatig margis of all of the firms i the sample at the start of the period. Fially, usig the dummy variable as our depedet variable ad the fiacial ratios (debt to capital ad operatig margi) as idepedet variables, we look for a relatioship: Distress Dummy = a + b (Debt to Capital) + c (Operatig Margi) Aswath Damodara 15
16 Step 3: Estimatig Distress Sale Value If a firm ca claim the preset value of its expected future cashflows from assets i place ad growth assets as the distress sale proceeds, there is really o reaso why we would eed to cosider distress separately. The distress sale value of equity ca be estimated as a percet of book value (ad this value will be lower if the ecoomy is doig badly ad there are other firms i the same busiess also i distress). As a percet of the DCF value, estimated as a goig cocer Aswath Damodara 16
17 Step 4: Valuig Global Crossig with Distress Probability of distress Cumulative probability of distress = 76.63% Distress sale value of equity Book value of capital = $14,531 millio Distress sale value = 25% of book value =.25*14531 = $3,633 millio Book value of debt = $7,647 millio Distress sale value of equity = $ 0 Distress adjusted value of equity Value of Global Crossig = $3.22 ( ) + $0.00 (.7663) = $ 0.75 Aswath Damodara 17
18 IV. Adjusted Preset Value Model I the adjusted preset value approach, the value of the firm is writte as the sum of the value of the firm without debt (the ulevered firm) ad the effect of debt o firm value Firm Value = Ulevered Firm Value + (Tax Beefits of Debt  Expected Bakruptcy Cost from the Debt) The ulevered firm value ca be estimated by discoutig the free cashflows to the firm at the ulevered cost of equity The tax beefit of debt reflects the preset value of the expected tax beefits. I its simplest form, Tax Beefit = Tax rate * Debt The expected bakruptcy cost ca be estimated as the differece betwee the ulevered firm value ad the distress sale value: Expected Bakruptcy Costs = (Ulevered firm value  Distress Sale Value)* Probability of Distress Aswath Damodara 18
19 Relative Valuatio: Where is the distress factored i? Reveue ad EBITDA multiples are used more ofte to value distressed firms tha healthy firms. The reasos are pragmatic. Multiple such as price earigs or price to book value ofte caot eve be computed for a distressed firm. Aalysts who are aware of the possibility of distress ofte cosider them subjectively at the poit whe the compare the multiple for the firm they are aalyzig to the idustry average. For example, assume that the average telecomm firm trades at 2 times reveues. You may adjust this multiple dow to 1.25 times reveues for a distressed telecomm firm. Aswath Damodara 19
20 Ways of dealig with distress i Relative Valuatio You ca choose oly distressed firms as comparable firms, if you are called upo to value oe. Respose: Uless there are a large umber of distressed firms i your sector, this will ot work. Adjust the multiple for distress, usig some objective criteria. Respose: Comig up with objective criteria that work well may be difficult to do. Cosider the possibility of distress explicitly Distressadjusted value = Relative value based upo healthy firms (1  Probability of distress) + Distress sale proceeds (Probability of distress) Aswath Damodara 20
21 I. Choose Comparables Compay Name Value to Book Capital EBIT Market Debt to Capital Ratio SAVVIS Commuicatios Corp % Talk America Holdigs Ic % Choice Oe Comm. Ic % FiberNet Telecom Group Ic % Level 3 Commuic % Global Light Telecom % Korea Thruet Co. Ltd Cl A % Williams Commuicatios Grp % RCN Corp % GT Group Telecom Ic Cl B % Metromedia Fiber 'A' % Global Crossig Ltd % Focal Commuicatios Corp % Adelphia Busiess Solutios % Allied Riser Commuicatios % CoreComm Ltd % Bell Caada Itl % Globix Corp % Uited Pa Europe Commuicatio % Average 0.87 Aswath Damodara 21
22 II. Adjust the Multiple I the illustratio above, you ca categorize the firms o the basis of a observable measure of default risk. For istace, if you divide all telecomm firms o the basis of bod ratigs, you fid the followig  Bod Ratig Value to Book Capital Ratio A 1.70 BBB 1.61 BB 1.18 B 1.06 CCC 0.88 CC 0.61 You ca adjust the average value to book capital ratio for the bod ratig. Aswath Damodara 22
23 III. Multiple Valuatio + Distress Value You could apply the average value to book capital ratio of all telecomm firms to value Global Crossig as a goig cocer. Goig cocer value = Average for telecomm firms * BV of capital for Global Crossig Oce you have the goig cocer value, you could use the same approach you used i the DCF approach to adjust for distress sale value. Aswath Damodara 23
24 Other Cosideratios i Valuig Distressed firms With distressed firms, everythig is i flux  the operatig margis, cash balace ad debt to ame three. It is importat that you update your valuatio to reflect the most recet iformatio that you have o the firm. The equity i a distressed firm ca take o the characteristics of a optio ad it may therefore trade at a premium o the DCF value. Aswath Damodara 24
25 Closig Thoughts Distress is ot restricted to a few small firms. Eve large firms are exposed to default ad bakruptcy risk. Whe firms are pushed ito bakruptcy, the proceeds received o a distress sale are usually much lower tha the value of the firm as a goig cocer. Covetioal valuatio models uderstate the impact of distress o value, by either igorig the likelihood of distress or by usig ad hoc (or subjective) adjustmets for distress. Valuatio models  both DCF ad relative  have to be adapted to icorporate the effect of distress. Aswath Damodara 25
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