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Under-performing companies present special valuation challenges. Financial distress adds an element of risk, which lowers value. So, compared with healthy companies, distressed businesses tend to have higher discount rates (under the income approach) and receive downward adjustments to pricing multiples (under the market approach), and sometimes don’t have past or projected earnings that contribute to the company’s value (under the cost approach). Or valuators might select guideline companies with similar financial performance or a proximate transaction date to avoid using deals that occurred during better economic times.

The Warning Signs

In every assignment, appraisers assess and benchmark financial health against industry norms. Warning signs of financial distress include weak demand, scaled-back corporate budgets, rising commodity prices and tighter credit. Financial statement trends — such as recurring net losses, declining or erratic sales growth and deteriorating liquidity — also are telltale signs that a company is in trouble. Examples of other red flags include late or missing financial records, high employee turnover and low morale. Also evaluate fixed-assets records. For instance, distressed sellers may defer maintenance, repair and equipment updates — or they may sell off fixed assets to generate extra cash flow.

When valuators recognize these signs, they can modify their appraisal approach to avoid over- (or under-) valuing a distressed business.

The Future vs. the Past

Financial distress creates specific valuation challenges. First, it’s unlikely that a distressed business’s historic financial performance will provide insight into its future performance, which makes projecting future cash flow more difficult. Future cash flow is important, because it determines business value under the income and market approaches.

If turnaround plans exist and appear reasonable, valuators may use these estimates to forecast future cash flow. If not, valuators might work with management to project future cash flow based on expected demand, not past performance.

Liquidation Value vs. Strategic Value

When buying a distressed business, liquidation value may be more important than going-concern value, particularly if the seller is under duress to exit the business. If liquidation value is the “floor” for purchasing a distressed business, strategic value is the “ceiling.”

In orderly liquidation value, valuators consider what the company would receive at an auction — and then subtract outstanding debt obligations. Strategic (or investment) value is the value to a particular investor based on individual investment requirements and expectations. For example, a competitor can afford to pay extra for buyer-specific synergies and economies of scale. (See the sidebar “Investment benchmarks.”)

Be Realistic

Distressed company sales and auctions may offer bargains, but don’t let rock bottom prices cloud your business judgment. Acquisition due diligence is exceedingly important. It’s imperative that business owners realistically assess the value of distressed businesses and their assets.

Sidebar: Investment Benchmarks 

The following financial metrics can help buyers evaluate whether asking prices make sense:

Accounting payback period. This tool estimates how long an investment will take to recoup its initial cost. For example, the payback for a machine that costs $200,000 and generates $40,000 in annual incremental profits is five years.

Breakeven point. Breakeven predicts how many units must be sold for an investment to cover its incremental costs. It equals incremental fixed costs (including depreciation) divided by the contribution margin per unit (which is equal to the price per unit minus the variable costs). If sales volume exceeds breakeven, an investment will generate profits.

Net present value. Here the analyst converts an investment’s projected cash flows to present values using an appropriate risk-adjusted discount rate. Buyers typically discount an investment’s cash flow using their cost of capital. Net present value equals this discounted cash flow. If net present value is greater than zero, an investment makes sense.