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eliminating the need to calculate the
discount rate, which can be extremely
complex depending on a company’s
capital structure. Instead, the market
multiples approach gauges how
much investors should be willing to
pay for each dollar of the company’s
cash flows by determining how much
they are willing to pay for each dollar
of similar companies’ cash flows.
The comparison can be made using
different measures of performance or
ratios applied to all the companies—for
example, price-to-earnings ratio (P/E)
or enterprise value-to-EBITDA (EV/
EBITDA). For a single valuation, more
than one type of ratio may be applied.
The two approaches are theoretically
equivalent and should yield similar
valuations, when done correctly.
The difference is that with market
multiples, the risk and cash flow growth
assumptions are implied by the market
multiple and are not explicitly stated.
In other words, the assumptions are
baked into the comparison by virtue
of applying the same measure across
all the companies. Consequently,
multiples valuation has the benefit
of capturing the market’s current
expectations of cash flow growth and
uncertainty, risk appetite, and other
macro factors, such as interest rates.
Companies May Be
in Chapter 11
By KOnStAntIn DAnILOv, ASSOCIAtE, AnALySIS GROuP InC.
record suggests that companies
filing for Chapter 11 are actually
overvalued more often than not.
The Impact of Risk on Valuations
A brief overview of valuation
approaches is helpful as background
for the discussion that follows. At its
most basic level, a company’s valuation
is a function of two factors—the future
cash flows the company is expected
to generate and the amount that
investors are willing to pay for those
cash flows based on their perception
of, and appetite for, risk. Because
the market’s risk appetite is fluid, it
is entirely possible that at different
points in time, the value of an asset
will fluctuate even if its “intrinsic”
future cash flows remain unchanged.
The most common valuation
approaches are the discounted cash
flow (DCF) and market multiples
methods. In a DCF analysis, the
company’s expected cash flows are
projected forward and discounted
back to the present using a risk-adjusted discount rate, such as the
weighted-average cost of capital
(WACC). The discount rate reflects—
among other things—investors’ current
risk appetite. A higher discount rate
lowers the present value of the asset.
The market multiples approach employs
a more direct route to valuation by
one of the most contentious parts of the bankruptcy process is establishing the company’s
valuation. Given the importance of
the final valuation in determining
the final recoveries for the various
claimholders, valuation hearings are
often lengthy affairs involving expert
testimony from various constituents.
Despite this robust process, some
have taken the view that firms in
bankruptcy are generally undervalued.
Valuation was a major focus of the 2014
Report by the American Bankruptcy
Institute’s Commission to Study the
Reform of Chapter 11, and many of
the report’s proposals were based
on the perception that bankruptcy
valuations are systematically skewed
toward undervaluing debtors.
On the surface, this idea is intuitively
appealing—after all, bankrupt firms are
generally experiencing unfavorable
conditions, and it seems logical that
these firms’ valuations would be
heavily discounted relative to their
“true” value. However, it is important
for all bankruptcy practitioners to
understand that valuation is much
more complex than it appears on the
surface and that it must be evaluated in
a relative, and not an absolute, context.
In fact, when valuations of bankrupt
companies are viewed in the context of
the prevalent market conditions at the
time of plan confirmation, the historical