Although there are signs that it’s waning, the great recession continues to challenge businesses nationwide. Some are still slipping into bankruptcy, while others are sticking to tight budgets to stay afloat. Struggling companies that remain in the game may be prime targets for a takeover. But if you’re on the lookout for an acquisition, make sure you do your homework.
Distress sales and auctions may offer bargains, but don’t let rock bottom prices cloud your business judgment. Acquisition due diligence is very important. That’s why bringing in an appraiser who can accurately assess and benchmark financial health against industry norms is a must.
Financial statement trends such as recurring net losses and declining or erratic sales growth are symptoms of a company in trouble. Others include missing financial records, fully extended lines of credit and denials for credit extensions. In addition, a business in trouble may be operating in the red and using fire sales of fixed assets to generate cash.
When valuators address these companies, they can modify their appraisal approach to avoid over- or undervaluing a distressed business.
Understanding value
When buying a distressed company, liquidation value may be more important than going-concern value — especially 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.”
Strategic (or investment) value is the value to a particular buyer based on individual investment requirements and expectations. For example, a competitor can afford to pay extra for buyer-specific synergies and economies of scale.
Financial distress creates specific valuation challenges.
First, it’s unlikely that a distressed business’s historic financial performance will offer insight to its future performance. Future cash flow is important, because it determines business value under the income and market approaches.
If turnaround plans exist and seem reasonable, valuators may use these estimates to forecast future cash flow. If not, they might work with management to project future cash flow based on expected demand, not past performance.
Financial distress adds an element of risk, which lowers value. So, compared with healthy companies, distressed businesses have higher discount rates and receive downward adjustments to pricing multiples. Valuators might select guideline companies based on similar financial performance or a proximate transaction date to avoid using deals that occurred during better economic times.
Finally, liquidation value plays an increasingly important role in valuing distressed companies. Here, valuators consider what the business would receive at an auction — and then subtract outstanding debt obligations. If the company is worth more in liquidation than as a going-concern business, it’s probably time to close shop.
Looking to acquire
Despite the difficulties that the recession has created for many businesses, it has opened up many opportunities for buyers looking to acquire a suitable company at the right price. If you’re in the market for a good deal, make sure you perform adequate due diligence before signing on the bottom line.
3 metrics for evaluating asking price
Three 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.
- Breakeven point. Breakeven predicts how many units a machine must generate to cover its incremental 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. If net present value is greater than zero, an investment makes sense.
