Session 13: Loose Ends - Distress, Dilution and Illiquidity

Introduction

In this section, the speaker introduces the three items that can reduce the value of equity in a company and explains how they differ from synergy and control.

Three Items That Can Reduce Equity Value

• The first item is distress, which refers to the chance that a company might not make it due to operational breakdown or too much debt.

• The second item is liquidity, which refers to how easy it is to sell an asset. If an investment is illiquid, its value will be reduced.

• The third item is dilution, which refers to the potential for share ownership to be diluted because more shares could be issued in the future.

Intrinsic Valuation

In this section, the speaker discusses intrinsic valuation and how it relates to discounted cash flow valuation.

Mechanics of Discounted Cash Flow Valuation

• Discounted cash flow valuation involves estimating the value of operating assets and subtracting out debt.

• Special issues such as synergy and control must also be considered in acquisitions.

Distress

In this section, the speaker discusses how distress can impact discounted cash flow valuation and provides an example using Las Vegas Sands.

Impact of Distress on Discounted Cash Flow Valuation

• Conventional discounted cash flow models assume that a company will last forever, but companies can run into trouble and shut down.

• Truncation risk refers to the risk that there may not be any cash flows in the near future because a company may not survive.

• When valuing a troubled company with a discounted cash flow model, it is important to consider the likelihood that the company may not make it.

• The speaker provides an example of valuing Las Vegas Sands assuming it will become a healthy company, but notes that this assumption does not reflect the possibility that the company may not survive.

Conclusion

In this section, the speaker concludes by summarizing the three items that can reduce equity value and emphasizing their importance in discounted cash flow valuation.

Summary

• Distress, liquidity, and dilution are three items that can reduce equity value and must be considered in discounted cash flow valuation.

• These factors are often overlooked in conventional models but can have a significant impact on a company's value.

Adjusting for Risk in Valuation

In this section, the speaker discusses how to adjust for risk in valuation by multiplying the promised coupon by the probability that the company will be around to make that coupon payment. The expected coupons can then be discounted back at the risk-free rate.

Adjusting Coupon for Risk

• Multiplying promised coupon by probability of company being around to make payment

• Discount expected coupons back at risk-free rate

Discounted Cash Flow Valuation

• Use price of bond, promised coupons, and credit rating to solve likelihood of default

• Value per share applies only in healthy companies (23% chance)

• Expected value is a weighted average with 23% weight and 0 with 77% weight

Understanding Liquidity Costs

In this section, the speaker explains what liquidity costs are and how they affect asset valuation. He also discusses different theories on how to reflect liquidity in asset valuation.

Cost of Buyer's Remorse

• Liquidity cost is cost of buyer's remorse

• Includes transaction costs and bid-ask spread

• More liquid assets have lower liquidity costs than less liquid assets

Reflecting Liquidity in Asset Valuation

• Two theories on reflecting liquidity in asset valuation:

• Adjust value after fact with liquidity discount

• Push up discount rate for illiquid assets

Building Transactions Costs into Asset Value

• Transactions costs should be built into asset value expectations

• Present value of transactions costs should be netted against current value

• Illiquid assets have higher discounts for investors with short time horizons or high transactions costs

Valuation of Distressed Companies

In this section, the speaker discusses how to adjust the expected return and cost of capital for companies that are less liquid. They also talk about how to factor in dilution caused by granting compensation in the form of options.

Adjusting for Liquidity Differences

• Illiquid assets should be worth less than more liquid assets.

• One approach is to push up the discount rate based on past data on higher returns from illiquid investments.

• Another approach is to add a percentage based on how much higher returns have been on illiquid investments versus liquid investments.

Dealing with Dilution

• Compensation given in the form of options can create an overhang on equity value.

• Options should be valued as options and subtracted from equity value estimated earlier.

• Future options should be treated as compensation expenses and reduced from operating income.

Loose Ends in Valuation

• For distressed companies, estimate a probability that your company will not make it and adjust your value for that probability.

• Liquidity differences across assets should be factored into valuation.

• Value options before valuing your share of equity in the company.