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Investing in distressed securities can seem complicated, yet the basics are straightforward. In this next note in our continuing series, The Turnaround Letter explores how to evaluate the potential pay-off from your investment in a distressed company.
Highlights: At its most basic, this step is straightforward--determine what the company could be worth if it recovers, then parse out the value between the debt and equity to estimate the potential upside. To value the company, traditional metrics like price/earnings ratios, price/book value ratios and dividend yields generally aren’t useful. Look to Enterprise Value/Ebitda on a post-recovery basis as an effective valuation method.
Discussion: Your analysis shows that the distressed company has a capable new management team and a credible plan for recovery. It can either raise cash or improve its operations to cover its debt, maintenance capital spending and other obligations. The company won’t violate any debt covenants and has other traits that make it a likely candidate for recovery. How do you determine the potential upside in its bonds and equity?
The first step is to estimate what the entire company could be worth if it recovers. Traditional valuation measures don’t translate well to distressed companies. Depressed or negative earnings produce meaningless price/earnings ratios. Book values may over-state obsolete assets or hide valuable assets. Dividend yields aren’t helpful as dividends are usually eliminated by distressed companies.
A more useful valuation method is Enterprise Value/Ebitda multiple. Enterprise value represents the value of all the core operations, which is then adjusted for the value of all the other long-term assets and liabilities of the company. Ebitda, or “earnings before interest, taxes, depreciation and amortization,” represents operating earnings with depreciation and amortization added back in – this approximates the cash operating earnings of the core business.
Look at your company from a post-recovery perspective. How much in revenues and profits could it produce? What would be a reasonable multiple to apply to its earnings? Could it build its cash balances and/or repay some debt? By looking into the admittedly murky future, you can build a rough estimate of what it all might be worth.
For example, if a company’s core operations could produce $1.25 billion in sales, and peer companies produce an average 10% Ebitda margin, we can roughly estimate that our company can earn $125 million in Ebitda once its recovery is complete. Perhaps these peer companies trade at 8x Ebitda – we can apply this multiple to value our post-recovery company at $1 billion.
Example: Distressed Company Valuation ($millions):
The next step is to parse out the value of the debt and equity. With an Enterprise Value of $1.0 billion, there is plenty of value to fully pay the $400 million in bonds, restoring their value to close to 100% of par value. If you bought your bond at 55 (or, 55% of par value), a price increase to 100 would produce a 73% gain, along with any interest payments you received while waiting.
Equity holders receive whatever value doesn’t go to other security holders. In our example, we deduct the $400 million in debt from the Enterprise Value, and then add the $100 million in cash, yielding $700 million in value for shareholders. Each share would be worth $14. If the current share price is $6, the potential upside would be $8 per share in gains, for a 133% return. Any interim dividends would add to this return.
In practice, you want to run several scenarios. Include more conservative assumptions, as recoveries usually are slower and less fruitful than initially expected. Be sure to consider competitive, cyclical and other factors that may trim revenues, constrain margins and reduce the multiple. Perhaps reduce the cash balance to reflect needed restructuring costs or capital spending. In more complex turnarounds, the Enterprise value would be further adjusted for cash raised from selling non-core operations and non-core assets like extraneous real estate, cash flow retained by the business, and any other long-term assets and liabilities.
Developing reasonable scenarios, assigning appropriate price multiples and making adjustments for assets sales and other transactions requires practice. Some companies and capital structures are impressively complex and may best be left to the experts. Many investors never acquire these skills and therefore wisely avoid distressed securities.
Others dig into the art and science of distressed investing to find treasures. If your candidate company shows a promising turnaround and has an attractive post-recovery valuation, you could have an attractive investment opportunity. Since investing in distressed securities involves considerable risk, your next step is to look at the downside if the recovery isn’t successful. We will explore that in The Turnaround Letter's next note in this Turnaround Investing Blog series.