As the economy continues to struggle, valuators often are asked to appraise financially distressed companies. The valuation approaches and methods experts use in these situations are essentially the same as those they use for healthy companies. But when a troubled company is involved, valuators may need to modify traditional methodologies and rely more often on personal judgment.

Choosing a method
Valuation methods generally fall under one of three basic approaches:

1.Income, which looks at expected economic benefits, such as cash flow or earnings, and converts them to present value using a risk-adjusted discount rate.

2. Market, which capitalizes earnings, revenues or other performance measures using market multiples derived from comparable public companies or actual transactions.

3. Asset, which measures the value of a business’s assets net of liabilities.

The appropriate method — or combination of methods — is determined by the subject company’s particular facts and circumstances, as well as the purpose of the valuation. But regardless of the valuation approaches used, the value of a business is derived from its ability to generate future economic benefits for a potential investor.

The income and market approaches generally provide more accurate values than the asset approach (and, therefore, are weighted more heavily), when a business is being valued as a going concern. Asset-based methods, on the other hand, may be appropriate when valuing a business for liquidation purposes or as a “reasonableness check” for other methods.

If a business being valued is distressed, valuators typically analyze it both as a going concern and in a liquidation context. This helps them determine whether a company is worth more “dead than alive.” When valuing a troubled business as a going concern, experts often emphasize the income approach. The market approach, on the other hand, may be less useful because comparable companies and transactions can be difficult to find.

Projecting future cash flows
Projecting future cash flow or earnings is the biggest challenge when valuing a distressed company. For healthy businesses, historical performance can provide a guide to what the future holds. But distressed businesses typically have poor track records, and recent performance may not be a good indicator of future potential.

Experienced valuators therefore dig deeper to identify the underlying causes of the company’s financial problems and determine whether a reasonable turnaround plan exists. If it does, the valuator can use the plan to estimate future performance.

Context is everything
Context is particularly significant when valuing distressed companies. If the business is being valued for sale, its viability as a going concern may depend on finding a strategic buyer that can take advantage of synergies, economies of scale or tax benefits to boost the distressed company’s revenues or reduce its costs. And if a bankruptcy reorganization is likely, the valuator needs to consider the impact bankruptcy protections will have on the company’ future financial performance.

The valuator also scrutinizes management’s efforts to keep the business afloat. Often, short-term survival strategies — such as discounting prices or slashing spending on advertising or R&D — can cause lasting damage to a company’s future prospects.

Troubled companies are riskier than healthy ones, and valuators incorporate this additional risk into their calculations. A valuator might use a higher discount rate under the income approach or lower pricing multiples under the market approach. Either way, the result is a lower overall value.

Judging value
Besides requiring valuators to use different appraisal methods and adjustments, distressed companies present special challenges. Often, these companies are unprofitable during the period leading up to the valuation date, so subjective judgment must play a greater role. Hiring an experienced valuator, therefore, is essential.

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