While every business valuation is different, struggling businesses do face unique challenges during the evaluation process. There is no one magic formula to decide the value of a company, these numbers are based on both qualitative and quantitative factors, which is further complicated by a failing company. A distressed company is defined by the inability to pay its financial obligations and must be treated differently during the valuation process.
There are a few key differences between the valuation of a distressed company versus the valuation of a fully functioning company. First, traditional valuation techniques operate under the assumption that a firm has continuing operations with no threats. This terminal value cannot be properly computed for a distressed company when the end is in sight. Second, discount rates and other multipliers need to be adjusted for the probability of failure.
While the overarching valuation methods remain the same, all the valuation formulas must be modified.
Methods of Valuation for Distressed Companies
Modified Discounted Cash Flow
In a traditional valuation, the discounted cash flow estimates the value of a company or investment based on its expected cash flows in the future. Cash flow equals the sum of money estimated from a scenario multiplied by the probability that it will happen. In a distressed company, which is not predicted to be successful in the coming years, the probability is a lot lower to accommodate for the distressed rate. The discount rate should also incorporate the distress.
Another popular method for valuation calculates the value of a company based on its competition and position in the market. To do this for a distressed company, one option is to compare the distressed company to the valuation of previously distressed companies. However, this is potentially risky because there may not be enough evidence of other distressed companies to create a proper valuation.
On the other hand, you can compare to healthy companies, while consciously adjusting for distressed value. However, there are also hesitations with this method as comparing to a healthy company may not be totally accurate.
The valuation of a distressed firm has many moving parts and is not an exact science, especially when traditional valuation methods cannot be used in their entirety. It is important to remember that all of these values are just estimates. There is no way to predict how successful a company is going to be 100% of the time. But these tools exist so that investors and business owners can make smart financial decisions.