Valuing Declining Companies

In this chapter of the little book of valuation, the focus is on the most challenging type of company to value – declining companies. The unique characteristics of declining companies present psychological, valuation, and pricing challenges for investors and analysts. In this session, the speaker provides insight into the complexities of valuing declining companies and offers guidance on addressing these challenges.

Psychological and Valuation Challenges of Declining Companies

The characteristics of declining companies make them particularly difficult to value. Historically, declining companies exhibit stagnant or shrinking revenues, decreasing margins, and a shift from profits to losses. Additionally, declining companies often divest assets, leading to disproportionately large cash payouts in the form of dividends and buybacks. The potential for overleverage further complicates the valuation process.

A significant psychological challenge in valuing declining companies is the inherent optimism or bias towards upbeat expectations. As human beings, individuals are hardwired to be optimistic, making it difficult to reconcile negative historical data and declining prospects.

Moreover, the valuation process itself is affected by the unique features of declining companies. Traditional valuation methodologies, such as subtracting reinvestment from after-tax operating income to calculate free cash flow, become challenging when reinvestment is a negative number, indicating divestment rather than investment in new assets.

Finally, the uncertainty surrounding the longevity and sustainability of declining companies adds to the complexity of valuation. The possibility of failure or a perpetually shrinking company introduces additional challenges in forecasting cash flows and determining terminal value.

Valuation Solutions for Declining Companies

When valuing declining companies, analysts must address the irreversible decline and potential distress. Determining whether the decline is reversible and assessing the likelihood of failure are essential steps in the valuation process.

Using the example of Bed Bath and Beyond, a brick and mortar retail company facing a significant decline, the speaker demonstrates the application of valuation techniques to assess the company's prospects. By projecting future revenues and operating income, incorporating negative reinvestment, and considering the possibility of failure, a valuation model for Bed Bath and Beyond is constructed. The assessment includes an optimistic scenario assuming the company's survival as well as a pessimistic scenario accounting for the probability of failure.

In the case of Bed Bath and Beyond, the valuation reflects the inherent distress and the associated risk of failure. The application of credit ratings and default probabilities provides additional insight into the potential outcomes for equity investors.

Pricing Challenges for Declining Companies

In addition to the valuation complexities, pricing declining companies presents its own set of challenges. Comparing the pricing ratios of declining companies to healthy, growing companies can yield misleading results. Finding comparable distress companies within the same sector may be difficult, and traditional pricing multiples may not adequately account for distress and decline.

The speaker acknowledges the limitations of using traditional pricing multiples for declining companies and highlights the importance of adjusting for distress and comparing to a subset of distressed companies within the sector. Ultimately, the pricing challenges for declining companies mirror the valuation challenges, emphasizing the need for careful assessment and consideration of distress and decline factors in the pricing process.

In conclusion, valuing and pricing declining companies requires a nuanced approach that accounts for their unique characteristics and challenges. With the guidance provided in this session, investors and analysts can navigate the complexities of declining company valuation and pricing, enhancing their ability to make informed decisions in the investment process.