Tuesday, June 30, 2009

Valuing declining and distressed companies

In my last post, I noted the difficulties that we face when valuing young companies. In particular, I noted both the difficulties we face in estimating cash flows for these firms and factoring in the possibility of failure. In many ways, we face the same problems at the other end of the life cycle, when valuing firms at the other end of the life cycle. In particular, declining and distressed firms share five characteristics:

1. Stagnant or declining revenues: Perhaps the most telling sign of a company in decline is the inability to increase revenues over extended periods, even when times are good. Flat revenues or revenues that grow at less than the inflation rate is an indicator of operating weakness. It is even more telling if these patterns in revenues apply not only to the company being analyzed but to the overall sector, thus eliminating the explanation that the revenue weakness is due to poor management (and can thus be fixed by bringing in a new management team).

2. Shrinking or negative margins: The stagnant revenues at declining firms are often accompanied by shrinking operating margins, partly because firms are losing pricing power and partly because they are dropping prices to keep revenues from falling further. This combination results in deteriorating or negative operating income at these firms, with occasional spurts in profits generated by asset sales or one time profits.

3. Asset divestitures: If one of the features of a declining firm is that existing assets are sometimes worth more to others, who intend to put them to different and better uses, it stands to reason that asset divestitures will be more frequent at declining firms than at firms earlier in the life cycle. If the declining firm has substantial debt obligations, the need to divest will become stronger, driven by the desire to avoid default or to pay down debt.

4. Big payouts – dividends and stock buybacks: Declining firms have few or any growth investments that generate value, existing assets that may be generating positive cashflows and asset divestitures that result in cash inflows. If the firm does not have enough debt for distress to be a concern, it stands to reason that declining firms not only pay out large dividends, sometimes exceeding their earnings, but also buy back stock.

5. Financial leverage – the downside: If debt is a double-edged sword, declining firms often are exposed to the wrong edge. With stagnant and declining earnings from existing assets and little potential for earnings growth, it is not surprising that many declining firms face debt burdens that are overwhelming. Note that much of this debt was probably acquired when the firm was in a healthier phase of the life cycle and at terms that cannot be matched today. In addition to difficulties these firms face in meeting the obligations that they have committed to meet, they will face additional trouble in refinancing the debt, since lenders will demand more stringent terms.

From a valuation perspective, using conventional discounted cash flow models can lead us to over value declining and distressed firms, where the possibility of distress is high. I think that we need to adjust the values that we obtain from DCF valuations for the likelihood that these firms will not make it. While there is no simple way to estimate the probability of failure, there are clues in the market that we can use to make reasonable estimates. I have a paper on the topic that you can download (if you are interested)

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1428022

Your comments are always appreciated.

4 comments:

Uiucfinance said...

Have there been any studies as to what management typically does in situations as such?

Seems like they have three options:

1)Go full bore ahead, borrow or sell off assets - i.e. leverage up, and bank on a quick recovery.

2)Steady as she goes, use normal means, cost cutting, small layoffs etc to try to make ends meet.

3)Throw in the towel, and realize what intrinsic value is left in the company, if the company is solvent, should leave some residual value for share holders.

On second thought, an interesting study would be what management does, vs what they "should have" done. I would have a feeling 1 and 2 are the most common actions for management, even if those actions are more damaging to shareholder value than option 3.

Aswath Damodaran said...

All of the above, but they tend to fight longer than they should (which is human nature), costing themselves, their stockholders and creditors more in the process.

Anonymous said...

... we need to adjust the values that we obtain from DCF valuations for the likelihood that these firms will not make it.

I am not sure if this is required as if we are not able to estimate cf we should give up. In my view the likelihood or unlikelihood of cf being achieved should be factored in estimating cf before we get on to dcf valuation. Once done that is your value.

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