In the Insolvency and Bankruptcy Board of India’s exam for Registered Valuer for the Securities and Financial Asset class, Situation Specific valuation is part of Valuation Application chapter from which around 2-3 MCQ are expected related to Distressed asset valuation, Start-up entities valuation, Valuation of small and medium enterprises, Valuation of cyclical firms, Valuation of investment entities and Valuation for insurance coverage. Therefore, for the purpose of clearing Registered Valuer exam of IBBI, one need to understand these concepts of situation specific valuation including the practical or numerical problems on start-up valuation specifically so that MCQ in exams can be solved without any error.

The techniques used to value distressed assets often involve estimating a range of possible outcomes or an expected outcome, understanding the extent to which the investor can influence those outcomes, and evaluating the risks and uncertainties around those outcomes.

Analysts who fall back on relative valuation as a solution to the problems of valuing declining or distressed firms, using intrinsic valuation, will find themselves confronting the estimation issues that we listed in the earlier sections either explicitly or implicitly when they use multiples and comparables.

1. Scaling Variable: All multiples have to be scaled to common variables, which can be broadly categorized into revenues, earnings, book value or sector specific measures. With distressed companies, earnings and book values can become inoperative very quickly, the former because many firms in decline have negative earnings and the latter because repeated losses can drive the book value of equity down and into negative territory. We can scale value to revenues, but we are then implicitly assuming that the firm will be able to turn its operations around and deliver positive earnings.
2. Comparable firms: There are two possible scenarios that we can face when valuing declining firms. One is when we are valuing a declining firm in a business where the remaining firms are all healthy and growing. Since markets value declining firms very differently from healthy firms, the challenge in this case is working out how much of a discount the declining firm should trade at, relative to the values being attached to healthy firms. We face the second scenario when we are valuing a declining/distressed firm in a sector where many or even all of the firms share the same characteristic. In this case, not only do our choices of what multiple to use become more limited, but we have to consider how best to adjust for the degree of decline in a firm. For instance, in early 2009, Ford, GM and Chrysler all showed signs of distress but GM was in the worst shape, followed by Chrysler and Ford.
3. Incorporating Distress: While analysts often come up with creative solutions to the first two problems – using multiples of future earnings and controlling for differences in decline, for instance – the presence of distress puts a wild card in the comparison. Put another way, when firms are not only in decline but are viewed as distressed, we should expect those firms that have a higher likelihood of distress to trade at lower values (and hence at lower multiples) than firms that are more likely to make it. Unless we explicitly control for distress, we will find ourselves concluding, based on relative valuation, that the first group of firms are undervalued and the second growth over valued.

When valuing a company as a going concern, there are three main valuation methods used by industry practitioners: (1) DCF analysis, (2) comparable company analysis, and (3) precedent transactions. These are the most common methods of valuation used in investment banking, equity research, private equity, corporate development, mergers & acquisitions (M&A), leveraged buyouts (LBO), and most areas of finance.

Method 1: Comparable Analysis (“Comps”)

Comparable company analysis (also called “trading multiples” or “peer group analysis” or “equity comps” or “public market multiples”) is a relative valuation method in which you compare the current value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or other ratios. Multiples of EBITDA are the most common valuation method.

The “comps” valuation method provides an observable value for the business, based on what other comparable companies are currently worth. Comps are the most widely used approach, as they are easy to calculate and always current. The logic follows that if company X trades at a 10-times P/E ratio, and company Y has earnings of $2.50 per share, company Y’s stock must be worth $25.00 per share (assuming the companies have similar attributes).

Method 2: Precedent Transactions

Precedent transactions analysis is another form of relative valuation where you compare the company in question to other businesses that have recently been sold or acquired in the same industry. These transaction values include the take-over premium included in the price for which they were acquired.

The values represent the en bloc value of a business. They are useful for M&A transactions but can easily become stale-dated and no longer reflective of the current market as time passes. They are less commonly used than Comps or market trading multiples.

Method 3: DCF Analysis

Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an analyst forecasts the business’ unlevered free cash flow into the future and discounts it back to today at the firm’s Weighted Average Cost of Capital (WACC).

A DCF analysis is performed by building a financial model in Excel and requires an extensive amount of detail and analysis.  It is the most detailed of the three approaches and requires the most estimates and assumptions. However, the effort required for preparing a DCF model will also often result in the most accurate valuation. A DCF model allows the analyst to forecast value based on different scenarios and even perform a sensitivity analysis.

For larger businesses, the DCF value is commonly a sum-of-the-parts analysis, where different business units are modelled individually and added together. To learn more, see CFI’s DCF model infographic.

The cost approach, which is not as commonly used in corporate finance, looks at what it actually costs or would cost to rebuild the business. This approach ignores any value creation or cash flow generation and only looks at things through the lens of “cost = value.”

Another valuation method for a company that is a going concern is called the ability to pay analysis.  This approach looks at the maximum price an acquirer can pay for a business while still hitting some target.  For example, if a private equity firm needs to hit a hurdle rate of 30%, what is the maximum price it can pay for the business?

If the company does not continue to operate, then a liquidation value will be estimated based on breaking up and selling the company’s assets. This value is usually very discounted as it assumes the assets will be sold as quickly as possible to any buyer.

From this piece of information, you must have realised by now that how important this concept of Situation Specific Valuation is from the point of view of IBBI registered valuer Examination. Therefore, Student’s unfamiliarity with this concept, its application; practical case studies etc. assuming that these areas are complex would not be appreciated and may cost the aspirant a lot. Therefore, I would like to encourage you all to study this situation specific valuation concept precisely and adequately. You can easily score those 1 to 3 marks in valuer examination that will make the difference between passing and failing.

What is eventually important for you is to study strategically and work on your weak areas with complete dedication so that you could pass the IBBI registered valuer examination. And for passing that examination with a minimum of 60% marks, these small and easy areas make a lot of difference. RVMOCKTEST.ONLINE is there to help you in this path of becoming a Registered Valuer by making you exam ready. You can check your preparedness and identify your mistakes, by appearing in online mock tests of RVMOCKTEST.ONLINE that will boost your confidence and increase your chances of clearing in one single shot!!

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