Should investors look at General Electric (GE, Financial), the once-great stock market hero that has since fallen upon desperate times? In 2000 it flirted with a $60 per share price, but since then has ratcheted down to less than $13.
"The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit" was published in 2011, before GE got into its current state, but the analysis Aswath Damodaran provides within it should help with valuations of declining companies at any time.
Why would we even consider declining companies? He wrote, “While investors and analysts often avoid these firms, they may offer lucrative investment opportunities for long-term investors with strong stomachs.” Those words could be a core philosophy for many value investors.
Damodaran added it is important to distinguish between mature companies and companies in decline. Several characteristics help define companies in decline:
- Revenues are declining or stagnant, particularly those that are growing at less than the inflation rate.
- Margins shrink or go negative because companies have lost their pricing power, resulting in tighter margins and loss of market share.
- Assets are divested since the assets may be worth more to other investors who can put them to better use.
- Dividends and stock buybacks are unusually large because decliners have little need for reinvestments.
- Financial leverage is backfiring as interest payments and principle repayments pull resources away from productive uses.
Investors or analysts using relative valuation will also contend with several estimation issues when using multiples and comparable companies:
- Scaling variables can quickly become inoperative or pointless.
- Comparisons with healthy companies makes it difficult to work out a discount for the declining company.
- Distressed companies trade at lower multiples and lower values.
Damodaran started an intrinsic analysis based on two key questions:
- Is the decline reversible (a “going concern”) or is it permanent?
- Will there be serious distress as the company declines; the author said not all declining companies are necessarily distressed.
His example is Las Vegas Sands (LVS, Financial); in early 2009 (when his analyses were made) it had been in a tailspin since September 2007, with its share price plunging from more than $130 to less than $2:
Damodaran noted the company did not look like a typical declining company because it had increased its revenues from $1.75 billion in 2005 to $4.39 billion in 2008, and also had two major casinos in development. However, it got into financial trouble in the fourth quarter of 2008.
He began his analysis with the assumption it would remain a going concern, so he estimated revenues, operating margins and taxes. He also assumed the company would have little capacity to reinvest. As a result, he projected little revenue growth in the following two years, before the new casinos opened and began to contribute revenue and cash flow. After that, he anticipated pretax operating margins would begin to improve and get back to an average of 17% per year in 10 years. He also expected the cost of capital to decline from 9.88% to 7.43%, as it paid off its expensive debt.
Damodaran completed his valuation by assuming Las Vegas Sands would hit stable growth after year 10 and then grow at 3% per year (equal to the risk-free rate cap). In addition, he assumed return on capital would earn 10% in perpetuity and stable period cost of capital would be 7.43%.
After discounting the cash flows, adding back the present value of the terminal value, adding back cash, subtracting the debt and dividing by the number of shares, Damodaran reached an initial valuation of $8.21 per share.
With that established, he moved on to the probability of distress, based on the company’s bond rating and the history of default among companies in that rating class. For Las Vegas Sands, that probability was 28.25%, based on its B+ bond rating. Damodaran then calculated its distress-adjusted value per share, which equals the initial valuation of $8.21 per share multiplied by the inverse of 28.25% (0.7125) plus 0 multiplied by 0.2825.
The formula produced a value of $5.89, approximately 30% above the stock price at that time of $4.25.
Turning to relative valuation, Damodaran argued there are two approaches available:
- Compare the distressed company’s valuation to that of other distressed companies.
- Compare with healthy companies, but adjust for the distress.
The problem with the first approach is that there aren’t always enough distressed companies at any given time to be able to make comparisons.
In the second approach, it was assumed the troubled company (Las Vegas Sands) would return to health in the future. An estimate of its future value is developed and then discounted back to arrive at a going-concern value. To that, the probability of distress and distress sale proceeds are added, as in the intrinsic section.
Damodaran first estimated earnings before interest, taxes, depreciation and amortization of $2.268 billion in year 10 and observed that healthy casinos were trading at an EV/EBITDA ratio of 8.25. Multiplying these two numbers gave him an expected enterprise value in 10 years of $18.7 billion.
He then discounted back to arrive at a current value of $7.68 billion. Should the company fail altogether, he expected proceeds from liquidation to be $2.769 billion.
All of that allowed him to calculate “value today” in this fashion: Value today = $7.658 (1 − .2825) + $2.769 (.2825) = $6.277 billion.
Dividing $6.277 billion by the number of shares outstanding produces an estimated share price of $3, well below the then-current price $4.25. Thus, we can conclude the stock was overvalued based on a relative valuation.
For value investors, the author’s work in this chapter provides a process that allows them to approach troubled companies in a quantitative manner. While the stories attached to stocks such as General Electric will remain important, relatively dependable dollar values and metrics will provide convincing help with buy and sell decisions.
The author: Damodaran is the author of three books on valuation and is a professor of finance and the David Margolis teaching fellow at the Stern School of Business at New York University. There he teaches corporate finance and equity valuation courses in the MBA program. His research interests lie in valuation, portfolio management and applied corporate finance.
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
