Asset Valuations in Reorganizations
Whether your engagement is liquidity or restructuring-related, calculating the reorganization value of the company is always important. The engagement may require valuing the entire entity as a whole or, conversely, valuing the company's assets separately. The subject assets may be tangible, such as rolling stock or inventory, or they may be intangible, such as a trade name or a customer list. Determining the value of all types of assets is essential when undergoing ordinary asset sales within §363 or when restating the balance sheet under fresh start accounting provisions.
There are numerous approaches commonly used to determine the reorganization value of a new entity. This article briefly addresses several of these approaches and states the usefulness of each in the context of a reorganization.
Acquired Cost or Book Value Approach
This approach considers the original cost of the acquired assets and is generally used only as a reference point in the determination of market value. Book value is an accounting convention, and the value of a company is generally not equal to a company's historical cost-based book value.
The Appraised or Replacement Cost Approach
Generally used to value the individual assets of a company, this approach is based on the cost required to replace an asset at current market rates less an allowance for physical deterioration (i.e., depreciation) and for economic, functional or technological obsolescence. Because the cost approach is based on the economic principle of substitution, it assumes assets of comparable utility are available in the market. If an asset is unique, however, the cost approach is nearly useless. Despite the apparent shortcomings of this valuation methodology, it is commonly the beginning benchmark for negotiations and purchase price allocations.
Multiple of Revenue or Turnover Approach
There are many businesses that, because of the fundamental nature of their operations, cannot be valued by the measure of their individual assets. Hourly service firms, fee or percentage-based companies, and other non-capital intensive companies (e.g., law firms, medical practices, travel agencies, etc.) generally cannot be valued based on their physical assets. Companies such as these often will be valued as a multiple of revenues. The multiple would be affected by economic, industry and company-specific factors, such as historical operating performance (after consideration of appropriate owner add-backs), experience of management, value of the customer list and the number of years of operation.
Multiple of Historical/Projected Cash Flow Approach
This method requires an estimation of revenues, expenses and appropriate levels of networking capital and capital expenditures. Estimates are made after thorough analyses and normalization of historical operating results. All of these factors are considered in estimating free cash flow.
The use of cash flow multiples often establishes the starting point to begin negotiations involving the value of a going concern entity. Entities that are acquiring companies with the plan to eliminate redundant overhead expenses generally prefer multiples of cash flow, rather than revenue, because they consider the incremental cash flows that will accrue to the acquiring company as a result of the acquisition. Multiples of cash flow will vary widely depending upon the state of the economy and the industry, as well as company-specific factors such as the availability of net operating loss carryforwards (NOLs), market share and any synergy that may be realized as a result of the acquisition.
The Discounting Cash Flows (DCF) Approach
The economic value of an entity equals the sum of its debt and equity values and is often referred to a corporate (enterprise) or shareholder value.1 For purposes of chapter 11, corporate value is the reorganization value. The DCF approach has commonly been used to estimate the reorganization value of the new entity. This approach discounts projected cash flows of the company to present at a rate equal to the company's cost of capital. The reorganized value is composed of three components:2
- the present value of the cash flows during the projection period;
- the present value of the residual value calculated at the end of the projection period; and
- the value of the assets considered unnecessary to operate the reorganized entity (this may consist of excess working capital, non-operating assets or assets that will be liquidated as part of the plan).
Residual value refers to the value of an enterprise at the end of the projection period. The projection period should continue until revenues, expenses and cash flow adjustments are normalized (or stabilized). At this normalized level, a company will no longer earn returns in excess of its cost of capital as it is assumed that these "excess returns" will be driven to zero by competition during the projection period. At this point, the subject entity will only earn, on average, its cost of capital on its new investments.3
The residual value is generally determined by capitalizing normalized cash flow after the last year of the projection period. This means that the cash flow at the end of the projection period is multiplied by the expected terminal growth rate, and this product is divided by the capitalization rate. The capitalization rate is the difference between the appropriate discount rate (usually the cost of capital) and the expected terminal cash flow growth rate. This methodology presents a problem when the terminal cash flow growth rate exceeds the discount rate.
The Earnings Capitalization Approach
This approach requires the calculation of sustainable prospective earnings and a capitalization rate. Prospective earnings should be adjusted for extraordinary factors. For instance, current earnings of a company in bankruptcy would likely require an adjustment because current earnings would underestimate the true earning ability of the company in a normal operating environment since it should show improved earnings in periods following emergence. In addition to identifying the extraordinary effects on a company's earnings while operating in bankruptcy, factors such as considerable capital investments, settlements or force majeure should be considered. As in the DCF approach, non-operating assets that do not contribute to earnings should be valued separately.
The capitalization multiple is simply the corporate (enterprise) value divided by the company's earnings. Capitalization multiples often are derived from the capitalization multiples of comparable companies in the marketplace. Earnings must be defined consistently when using comparable companies to determine capitalization of earnings multiples.
Valuation of Intangible Assets
Probably the most perplexing area of valuing assets, and also the subject of the most criticism, involves the valuation of intangible assets. Intangible assets include trademarks, trade names, customer lists, lease assignments and the ever-mystic goodwill.
The valuation of leases is relatively straightforward if market demand and comparable property information is available and analyzed carefully in determining the property's relationship to market value. However, an auction of those leases can often reveal a competitor's demand for market positioning or a desire to upgrade a neighboring site.
The sale of a trade name or trademark is generally more difficult than a lease and typically warrants an auction sale to identify potential buyers. The sale of the name "Pan Am" reportedly brought $500,000 to the bankrupt estate, for example.
Valuing a customer list is particularly challenging because of the uncertainty related to perceived value by bidders. Several issues affect the value of a customer list, such as the proprietary nature of the product line, corresponding sales and historical data, the ability to duplicate from other public sources, and synergy opportunities. The author has used ranges of 0.1 to 1.0 percent of historical sales for low- and high-margin businesses, respectively. Once again, such a conclusion of value should be considered only as a starting point. All relevant factors should be considered in concluding the value, including the use of a "stalking horse" to determine preliminary interest.