Absolute vs. Relative Value
From a practical perspective, firm
valuation is notoriously subjective and
the mere definition of “overvalued”
versus “undervalued” is not
straightforward. The ABI report notes
that “[a]lthough the valuation at any
point in time will necessarily reflect the
debtor’s future potential, the valuation
may occur during a trough in the
debtor’s business cycle or the economy
as a whole, and relying on a valuation at
such a time may result in a reallocation
of the reorganized firm’s future
value in favor of senior stakeholders
and away from junior stakeholders”
[ABI Report at 207]. This implies that
valuation is an absolute value based
on the recoveries of creditors and,
accordingly, that undervaluation is
associated with lower overall recoveries.
However, the reality of valuation is more
complex than this view of absolute
valuation levels would suggest.
A stylized example is helpful to
illustrate these concepts: XYZ Co. is
a bankrupt firm with $75 in creditor
claims, including senior creditors
($50) and junior creditors ($25). Two
alternate hypothetical scenarios are
presented below, with the assumption
that both valuations are performed
the same exact way and that the
difference between the two scenarios
represents alternate states of the world:
Scenario 1: XYZ Co. is valued at $50
and is expected to generate $10 of cash
flows in the following year, reflecting
a continued slowdown in its industry.
Scenario 2: XYZ Co. is valued at $75
and is expected to generate $25 of cash
flows in the following year, reflecting
a rapid recovery in its industry.
The commission’s view would suggest
that in Scenario 1 the company is
“undervalued” by $25 relative to Scenario
2 because there are lower overall creditor
recoveries in this scenario. There is
just enough value to repay the senior
creditors, who will now own the equity
of XYZ Co., while the junior creditors
and equity holders are out of the money.
According to this view, Scenario 2
would be preferable because it would
repay the senior claims and provide
the junior creditors with XYZ equity
worth $25 (the new capital structure
is simplified for ease of calculation).
While on the surface this seems to
make logical sense, this absolute view
of valuation is inconsistent with reality.
Valuation is always a relative measure,
so focusing solely on the absolute levels
can often be misleading. For instance,
the Scenario 1 valuation level of $50
implies a valuation multiple of 5 times
XYZ Co.’s annual cash flows (50/10 = 5x),
while Scenario 2 implies a multiple of
only 3 times cash flows (75/25 = 3x).
This type of analysis is the basis for
guideline company valuation and is
one of the most common ways used to
evaluate firms. As discussed earlier, these
multiples reflect investors’ expectations
regarding XYZ’s future growth prospects,
its risk, and the opportunity cost of
investing in XYZ as opposed to all other
available investments. In isolation,
calculating these multiples doesn’t
provide any additional insights into the
question of over- or undervaluation;
there is no way of judging whether a
multiple of 5x or 3x is either high or low.
The more informative barometer would
be comparing the company measures
to broader industry trends, which is one
way to gauge the relative (as opposed
to absolute) valuation level of XYZ Co.
For example, assume that comparable
companies in this industry are on
average trading at multiples of 4x annual
cash flows during this time period.
Investors would now view XYZ Co.
as overvalued in Scenario 1 because
similar companies are valued at 4x
cash flows, while XYZ Co. is valued at
5x cash flows. Given this information,
although in Scenario 1 XYZ Co. senior
creditors would receive $50 toward
their claim, it would actually be worth
$40 (applying the market multiple of
4x times $10 cash flows = $40 total firm
“fair” value). On the other hand, with
a multiple of 3x in Scenario 2 XYZ Co.
is undervalued, and junior creditors
would receive all of the XYZ equity
(actually worth $50 after the senior
creditors take their share, given a total
firm “fair” value of 4x times $25 = $100),
at the expense of the equityholders.
Historical valuation levels provide
yet another way to view bankruptcy
valuation levels from a relative
perspective. Returning to the earlier
example, assume that valuation
multiples have historically averaged
7x for the broader stock market.
Viewed in this context, XYZ Co. is
undervalued in both Scenario 1 (5x
multiple) and Scenario 2 (3x multiple)
relative to historical valuation levels.
By now it should be evident that,
Although valuation in the real world is much more
complex than this highly stylized example, it
helps illustrate that the concept of undervaluation
is much less straightforward than it would
appear on the surface and exposes the dangers
of viewing valuation in an absolute context.