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Enterprise value approach
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Option value approach
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Market value approach
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Relative value approach
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Scenario analysis
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Here’s what else to consider
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When a company is in financial distress, its creditors and shareholders may have different claims on its assets and cash flows. Valuing these claims is a crucial step in restructuring, whether it involves a debt-for-equity swap, a sale of assets, or a bankruptcy proceeding. In this article, you will learn how to use different valuation methods and techniques to estimate the recovery value of distressed company claims.
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1 Enterprise value approach
One way to value distressed company claims is to estimate the enterprise value (EV) of the company, which is the sum of its equity value and net debt. EV represents the present value of the company's future free cash flows, discounted at an appropriate weighted average cost of capital (WACC). You can use various methods to estimate EV, such as the discounted cash flow (DCF) method, the multiples method, or the asset-based method. Once you have the EV, you can allocate it to different claimholders based on their priority and seniority in the capital structure.
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2 Option value approach
Another way to value distressed company claims is to use the option value approach, which treats equity as a call option on the assets of the company, and debt as a combination of a risk-free bond and a put option on the assets. The option value approach is based on the Black-Scholes-Merton model, which requires inputs such as the volatility of the assets, the risk-free rate, the time to maturity, and the strike price. The strike price is the face value of the debt, which represents the amount that equityholders have to pay to exercise their option. The option value approach can capture the non-linearity and asymmetry of equity and debt values in distress situations.
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3 Market value approach
A third way to value distressed company claims is to use the market value approach, which relies on the prices of the company's securities in the secondary market. The market value approach assumes that the market prices reflect the expectations and preferences of the investors, and that they incorporate all the relevant information about the company's prospects and risks. The market value approach can be useful when there is sufficient liquidity and transparency in the market, and when there are no significant market frictions or distortions. However, the market value approach can also be affected by factors such as market sentiment, speculation, arbitrage, and trading costs.
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4 Relative value approach
A fourth way to value distressed company claims is to use the relative value approach, which compares the company's securities with those of similar companies or industry benchmarks. The relative value approach can help to adjust the valuation for factors such as size, growth, profitability, leverage, and risk. The relative value approach can use various metrics and ratios to compare the securities, such as yield to maturity, yield to worst, recovery rate, credit spread, price to earnings, price to book, and enterprise value to EBITDA. The relative value approach can provide a range of valuation estimates based on different comparables and assumptions.
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5 Scenario analysis
A fifth way to value distressed company claims is to use scenario analysis, which involves creating different scenarios of the company's future performance and outcomes, and assigning probabilities and values to each scenario. Scenario analysis can help to account for the uncertainty and variability of the company's cash flows, costs, revenues, and growth rates. Scenario analysis can also incorporate different restructuring options and strategies, such as refinancing, restructuring, liquidation, or merger and acquisition. Scenario analysis can provide a weighted average valuation estimate based on the expected values of each scenario.
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6 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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