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— Analysis —
Emerging from the credit crisis that rocked the economy in the fourth quarter of 2008 and seeing an economy facing a potentially prolonged downturn, traditional valuation measures that compare transactions or consider Ebitda multiples do not necessarily provide a clear answer. Enterprise values have plummeted. The declines in enterprise values, which typically include both equity and debt, are due to poor performance, liquidity concerns and significant uncertainty. Compared with previous economic periods, the clarity of information required for properly employing traditional valuation methods is less apparent. Therefore, it is helpful to highlight some of the issues we see affecting valuation.
-- See related stories on valuation -- Out of kilter First, and slightly obvious, there is a disconnect between the indications derived using the three traditional valuation approaches: discounted cash flow, market comparable and transaction. In reconciling the differences, the management forecasts used for the discounted cash flow analysis may not consider all the risk that the market is evidently forecasting. In addition, potential issues can be encountered in trying to adjust the cost of capital for such risks. Cost-of-capital rates are viewed in relation to the risk-free rate as measured by long-term Treasury yields. Yet the recent dramatic flight to quality and subsequent drop in the risk-free rate to historic lows may distort the cost-of-capital forecasts. When using historic market-risk premiums and the current low risk-free rate, the cost of capital may actually appear lower than in less volatile time periods. Therefore it may be appropriate to either adjust the forecasts or apply risk premiums to the cost of capital. Another item to consider in the cost of capital is the optimal capital structure of market participants. Recent dramatic declines in equity values may suggest that current debt-to-equity ratios misrepresent optimal capital structures. To accurately value a business, it may be appropriate to consider a longer period of debt-to-equity ratios. This adjustment will affect the long-term cost of capital as well as levered betas. The market-comparable analysis typically uses enterprise multiples derived from earnings before interest, taxes, depreciation and amortization, or Ebitda. Determination of enterprise value relies on adding the market value of the comparable companies' debt and equity. Given the current economic factors -- including quality of debt value -- comparable companies' enterprise value multiples may be ambiguous and require increased analysis and use of judgment. Utilizing the book value of debt may lead to artificially high multiples when dealing with financially distressed comparable companies. Special consideration should be given to the market value of debt when a comparable company's equity value is very low and highly volatile. These conditions may suggest that the equity is practically worthless and may be trading based on its option characteristics. If so, the market value of debt will probably differ greatly from its book value. Under such circumstances, consideration for other methods such as Black-Scholes and discounted cash flow to equity holders [versus to the firm] is warranted in the valuation of equity. Like enterprise values, transaction volume has also seen significant declines. The limited number of recent transactions makes it difficult to use a transaction approach to derive value. If used, it may be appropriate to give it less weight than other approaches when concluding the enterprise valuation. Transactions are also used in establishing control premiums. A limited sample of transactions may actually lead to an inference of a wider range of premiums being paid for control. In certain transactions, negative premiums are also indicated. Consequently, caution should be paid to the application of control premiums using current transactions. Last, in addition to the approaches themselves, liquidity is a noteworthy factor in valuations. Fears of illiquidity have reduced values in recent periods. Liquidity may already be embedded in the underlying price of a security, or it may require a discrete adjustment. Either way, liquidity and marketability discounts should be considered in many valuation situations. In this exceptional environment, valuation requires exceptional caution. The challenges are not insurmountable, but a thoughtful assessment of the factors used in traditional valuation approaches is critical to come up with meaningful valuation conclusions. Bryan Browning is senior vice president of Valuation Research Corp. |
What is a business worth today? Clearly, traditional valuation measures face some real challenges.
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