By Edward B. Cordes & Layne Kottmeier
Business valuation is predicated on events that will occur in the future and is entirely dependent upon assumptions the valuation analyst makes about those future events. As such, there is an element of risk associated with most valuations – that is, the risk that those assumptions regarding future events will prove to be correct.
Valuations performed in situations of insolvency inherently involve even more risk, as the future of an insolvent company is much more difficult to predict than that of a healthy company. Consequently, valuations prepared in the context of bankruptcy will often have widely disparate values. The key to understanding and using such valuations lies in a careful and critical examination of the underlying assumptions that the valuator has made.
Premise of Value
The valuation analyst must make an initial determination with respect to premise of value that underlies the valuation. That premise of value will be one of two – will the entity survive and continue to operate, or will its assets be liquidated and the entity eventually dissolved? Those businesses which have fallen into insolvency due to an adverse one-time event, such as a malpractice judgment or an isolated poor business decision may be candidates for reorganization and continuation. If however, the business has failed due to a declining demand for its products or services or due to competition from new sources it might be a serious candidate for liquidation.
This distinction is critical because, if the assumption is that the entity will not survive, then its value will be significantly lower, for a variety of reasons.
For example, assume the insolvent entity is an outpatient imaging center. The value of that center’s assets in liquidation will be lower than if it were a going concern because:
· The realized collections on outstanding accounts receivable will be lower as staff is usually no longer in place, and some debtors see an insolvent creditor as a chance to avoid paying.
· Inventories of supplies are typically not returnable and must be sold at drastically reduced prices.
· Equipment which may still have functional worth but is not the more recent technology is usually disposed of at nominal prices.
· Leasehold improvements built to accommodate specific equipment and medical needs must be abandoned.
· Any intangible value associated with the entity name or reputation is typically lost.
· The costs of asset disposal and administration of the liquidation process are significant.
Valuation as a Going Concern
For obvious reasons, then, when a business reaches the point of insolvency, a restructuring or reorganization, if successful, is usually in the best interests of both creditors and equity owners.
If the valuator assumes a going concern premise, then certain assumptions must be made about the entity’s future operations. Usually, such assumptions are based, in part, on the entity’s historical performance. With an insolvent business, however, the valuator must assume that something will change going forward – and that change must be an action or circumstance that the valuator projects will improve the business’ future operating results. For example, the imaging center discussed previously might discontinue a service that has not been profitable or, if creditors are willing, it might add new equipment that would give it a competitive edge. Perhaps it has two locations that could be combined with associated cost savings.
Whatever the assumptions are regarding the business’s future operations, the valuator must convert those assumptions to estimates of future revenue and expense.
Valuators rely on three basic approaches to value a business – an asset-based approach, an income-based approach and a market-based approach.
Asset-based approaches are typically applied in a liquidation scenario, such as previously discussed, although they are also used in other circumstances where the value of the entity resides primarily in the assets it holds.
An income-based approaches requires that future profits or cash flows be estimated, and then those future benefits are converted to a present value. The conversion to present value requires the application of a discount rate, which reflects the risks associated with the future cash flows.
Market-based approaches typically involve the application of a price earnings ratio from a similar business, to the business being valued, to derive a value. To make that application, the valuator must have made assumptions about the earnings of the entity being valued.
Both income and market-based approaches can be used in the valuation of an insolvent business, under the assumption that future operations will be profitable. Thus the assumptions that the valuator makes about the future profitability of the entity are critical to the conclusion of value.
Assumptions Regarding Future Operations
Assumptions about future prospects consider both the internal components of the business as well as the external forces which influence the prospects of a business. Major categories of assumption would include financial measures such as sales, margins, expenses and capital required. Operational assumptions include areas such as the confidence of the market in a business’s products and services, the effects of competition, the ability of current or new management to implement new strategies, and the cooperation of suppliers.
Sales can be adversely affected by a public display of insolvency, such a bankruptcy filing, particularly where the goods or services provided have a warranty or service period extending beyond the sale. There should be valid reasons supporting any change in the trends established in the pre-insolvency period. Sales forecasts need to be looked at in conjunction with product line changes, changes in sales outlets, and changes in marketing and sales strategies.
Projections regarding gross profit margins should be viewed with a similar skepticism. Margin is affected by changing the sales price of the goods and services offered, or by reducing the cost of providing those goods and services. Assumptions here should be consistent with the rest of the plan. Increasing sales volume and price is often difficult. Assumptions regarding sales must be linked to the organization’s productive capacity, taking into account not only its physical plant, but also its available human resources.
Cost reductions are often an assumption in the valuation of an insolvent entity. The cynic might wonder why such costs were not removed before the insolvency if they were not needed. Assumptions with regard to the entity’s cost structure, however, may be less speculative than assumptions with regard to increasing sales, particularly if they are tied to an anticipated action, such as a labor force reduction or renegotiated contracts. An entity in bankruptcy can void items such as unprofitable leases and onerous contracts, thus setting the stage for future cost reductions.
Forecast assumptions should also be consistent with industry and economic conditions. Industry background as well as financial and operating statistics are readily available from sources such as NACVA’s “Physicians and Group Practices Consulting: Basics, Transactions, Valuations and Practice Improvement,” (www.NACVA.com). Forecasts can then be compared with prospects for the entity’s products or services, issues regarding technological obsolescence and other trends within the industry. Current economic conditions and expected economic trends should also be considered in challenging the assumptions used by the valuator.
Business valuations are derived by discounting projected cash flows to present value using a discount rate that reflects the risks inherent in the business being valued. Thus, the discount rate used by the valuator is a critical assumption in the valuation analysis and often the source of much debate. Investing in large publicly-traded companies bears a risk factor of approximately 12 percent, according to information compiled by Ibbotson and Associates. In the case of an insolvent entity, the valuator must determine the incremental risk associated with an entity which is emerging from circumstances which are often financially fatal. Indeed, according to Practitioners Publishing Company’s “Troubled Business and Bankruptcies,” only about 20 percent of small companies that file for reorganization under a Chapter 11 bankruptcy emerge successfully. The rest fail; thus the discount rate used by the valuator must reflect this greatly increased level of risk.
Valuations are necessary during insolvency in order to measure economic value for the benefit of both debtors and creditors. But the valuation process involves making assumptions about an entity’s financial future which are of necessity different from its financial past. Thus, a rigorous analysis of those assumptions is requisite to a thorough understanding of the reliability of the conclusion of value.
Edward B. Cordes and Layne Kottmeier are employed in the Denver office of Cordes & Company, which provides valuation services and insolvency consulting including acting as Receiver and Trustee.