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Introduction to Distressed Analysis – Developing Your Investment Thesis and Valuation Methods

Introduction to Distressed AnalysisOk, time for a more in depth look at making a thesis and a valuation.

From the outset, I want to underscore a point raised in my previous article here, that most investors will want to enter the distressed investing space by relying on the expertise of various funds that focus on these types of investments. Thus, I’ll first address here the constraints that an individual investor faces, and how one who is determined to make his or her own picks can gain an advantage over others in the markets. You may not have the resources that top level investors have access to, but with some elbow grease and some patience you can find attractive opportunities to exploit – particularly if you’re investing in companies that you already understand from personal experience.

Then, we’ll explore the basics of valuation methodologies, and why your personal experience can give you an advantage when making a valuation. This will help whether you are making your own individual picks or not, so that you can understand the various processes employed by the fund managers and analysts you are relying on (which some may now suspect to be no more sophisticated than the throwing of darts). The ultimate purpose of it all is to develop an investment thesis, which ideally is a written explanation for why you chose a certain investment, so that you not only go through the process of formulating into words your reasoning behind making a choice, you have a record of those thoughts that you can refer back to.

Typically, most of the companies that an individual investor is going to be considering fall outside of their direct experience and personal area of expertise; and that’s completely reasonable–you can’t be an expert at everything! The expertise I’m referring to is that ability to carry on meaningful conversations about an industry with someone who’s spent their life in it, whether it’s the finer points of a new type of diagnostic test for knee injuries or the migration to a different type of drill bit for oil exploration. An expert in the field knows more than just the general idea behind these developments—he or she knows who has been successful at capitalizing on them and who hasn’t, and why. The experts even have their own “war stories” to relate to others.

When it comes to valuing a company, we would generally consider an expert to be someone who can name that company’s main competitors, list the issues that are going to affect the industry in the next few years, describe  the impacts on the company in terms of changes to the business and customer base, and explain the different factors that move the company’s value. Even for an intelligent person looking at an industry on a daily basis, this level of expertise could take anywhere on the order of 5-10 years.

Most people are going to be hard pressed to get that sort of an understanding of a specific company. However, if you have been working in, or exposed to, a certain industry for a while you have a front row seat to the action and a direct pipeline to valuable knowledge. You would probably know better, and sooner than Wall Street would know. Peter Lynch, the great Magellen Fund manager, said that people should “invest in what they know.” There will be one person who knows better, or at least sooner, than a knowledgeable analyst may, and that’s precisely the type of person on the ground that an analyst would seek out in their own process of making a thesis. Obtaining such an expert’s perspective is really important because there are different ways to value companies, and even if one performs all the valuation calculations correctly, there are different methods and by following each you can arrive at different answers as to a company’s value! So, knowing the industry and what drives a correct valuation is paramount.

Now for the valuation methods, of which there are five main types that the savvy investor should be familiar with: precedent transactions, discounted cash flows, sum-of-parts, market comparisons, and market valuations. How do these look in the real world?

The prime example of a precedent transaction is when a company is bought out by another. It can be one of the best ways of determining valuation because another party with a huge financial interest has already presumably done a serious amount of due diligence to determine a price it is willing to pay. Of course, a purchasing company may be willing to pay a premium because of other benefits it receives, such as the ability to consolidate operations and thus cut its own overall costs as well as those of the acquired company, access to a new customer base and various proprietary information, and gaining control of what would otherwise be a hard-nosed competitor, etc. Precedent transactions like a buy-out can also reduce the possibility of financing problems that you might otherwise have to consider carefully. For example, a smaller company you may have thought of investing in only had a few quarters’ worth of cash on hand (like many medical research companies), and if it ran into trouble it might have big problems in obtaining new financing. If that company is bought out by a major parent corporation with lots of cash, such concerns fall away and your confidence level rises. (These benefits are often referred to by the buzz-words “synergies” and “economies of scale.”)

Mario Gabelli revolutionized the precedent transaction analysis, and his methods are worth delving into (such as here).

A discounted cash flow (DCF) analysis looks at recent and projected revenues, and then applies a discount to current value based on how long one might have to wait for increased revenues. Medical research companies provide a great example for this, such as one that is in a testing phase for bringing a vaccine to market. You may see their product as worth $1 billion in revenue over 20 years, if they succeed at the 50/50 chance of passing tests and overcoming other hurdles. So, you consider the risks to success, and calculate value based on a discount in which future years’ projected revenues are offset by the time value of waiting for the revenue to come in (and then further discounted based on the “likelihood of success” factor—in this case, 50%). If the vaccine is successful, the billion dollars in revenue will not appear overnight—so you can’t value the company today at $1 billion. Each successive year of projected profits is less valuable today because of the lack of immediate access to that money (what to speak of the potential for new challenges to pop up, like lawsuits that can damage a product’s reputation or cause it to be pulled off the market).

A DCF analysis can be tricky for a number of reasons, but they are ubiquitous and very powerful. Check out this link to see an example of one.

Next, consider a company that owns timber land. Let’s say they own 50,000 acres of land in a certain area with a certain type of wood. For this you would want to use a sum-of-parts valuation, for which you would simply calculate the value of the various assets of the company, add them up, and then factor in the intangibles like goodwill. Some hardwoods fetch upwards of 5000 dollars per acre. Interestingly, timber prices can be very stable—they were actually very stable before and after the financial crisis of 2008—but since there are liquidity issues at times, with inventories unable to move, a timber company’s value would likely have to be discounted during such times. So, despite stable prices in a market, Illiquidity of inventory can lead to significantly lowered prices of the assets of a company in that industry. Also, don’t forget to include cash on hand, interests in real property (over and above that which relates to the core business, such as in our timber company example), and other investments when doing a sum-of-parts valuation.

This type of valuation can be especially useful when analyzing companies with multiple divisions, as the sum of the value of each individual division (i.e., considering their individual value on the market if they were each sold independently) could vary widely from how the market is currently valuing the company as a whole. Indeed, this is a good test to see how much of a premium (or discount) the market is setting on intangible values of the company, given that in theory a company should at least be worth the sum that its individual divisions would yield if sold off as is.

A market comparison essentially uses one or more of the above types of analyses, but rather than applying directly to the company to be valued you apply them to similar companies in the field and then calculate a mark-up or mark-down to the company you’re trying to value based on how it differs in size, debt, and other obvious attributes. This type of analysis can be extremely helpful when you have already at your fingertips some thorough, reliable analyses or precedent transactions for similar companies in the same industry as the one you’re concerned with. For example, if you’re valuing Company A and a similar company B was just sold for $80 million, then you could compare the debt load and other liability exposure, assets, revenue stream, etc., of Company A to Company B and get a good idea of what a similar buyer should be willing to pay for Company A.

The last, generally least-reliable valuation, although easiest (and least interesting), to think about is the market value of a company. This is simply the number of shares of stock in the company multiplied by the stock’s price. You can observe this valuation in action on Google, Yahoo Finance, and any of a number of other sites for any stock.

However, market valuations are subject to a number of factors that may obscure a company’s true value (or lack thereof). Analyst reports, ratings, news items, insider activity, and a host of other issues can trigger knee-jerk reactions in which investors flock or flee from a given stock. Thus, while market valuation can certainly tell you clearly the level of a stock’s popularity at the moment, and provide an initial step for investigating what is driving that popularity rating, it is not the purest of litmus tests upon which to place your confidence.

And let’s not forget the golden rule when it comes to stressed and distressed companies–always remember that in a bankruptcy, stock is essentially rendered worthless, with the company’s assets sold off to repay the various levels of creditors first. Only afterwards are stock holders compensated, if at all.

In a follow-up article, I will demonstrate how we apply valuation methods specifically to our test case, Salon Media.

In the meantime, consider checking out some of these excellent presentations and pieces:

Bill Ackman, a well known value investor, discusses some valuation methods in this video. It’s really intuitive, and I’ve sent it along countless times to friends who have been looking to get an understanding of accounting, in the lens of a particularly ambitious and high growth lemonade stand. https://www.youtube.com/watch?v=WEDIj9JBTC8

Michael Price, the former head of Franklin Templeton, describes in detail how he thinks about value, as well as how he looks for new ideas for investments  – an eloquent, intuitive and highly accessible, and highly elucidating presentation  – http://www7.gsb.columbia.edu/video/v/node/1363

Learn to Earn; One up on Wall Street; Beating the Street – Three really great books and easy to read books by Peter Lynch, one of the greatest value investors of all time. His track record of an average of 29.2% returns over 14 years (double the stock market average) while managing the Magellan Fund at Fidelity marked him as one of the best portfolio managers of all time. He also coined the mantra that one should “Invest in what they know,” which marks his style of investing out as one of the most intuitive and accessible strategies.

Here’s an interesting and more exhaustive case study of another distressed company, as laid out by Houlihan Lokey, a well known bank in the distressed/restructuring space – http://www.hl.com/library/bsttcacs.pdf

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