Page 43 - Bankruptcy and Reorganization Services

Step 1: Identify and Select Guideline Companies

In order to identify and select guideline companies, the valuation analyst should establish criteria for the
selection of guideline companies. Criteria to be considered may include

 industry similarity,

 size,

 operating characteristics,

 financial characteristics,

 growth prospects, and

 other factors.

When the subject company is in financial distress, the search for guideline companies can be problemat-
ic. Whereas the practitioner typically searches for guideline companies with financial performance com-
parable to the subject company, searching for guideline companies that are also in financial distress is
not necessarily appropriate. Companies can be in financial distress for many reasons. The market multi-
ples of companies in financial distress will reflect the company-specific circumstances that may be caus-
ing the distress and may not be applicable to the subject company. Also, the stock prices of companies in
financial distress behave erratically, which can result in volatile movements in the observed market mul-
tiples over relatively short periods. The resulting volatility of market multiples can make the multiples
less reliable indicators of value. Accordingly, it is often preferable to find healthy guideline companies
that are otherwise comparable to the subject company. The market multiples derived from the healthy
guideline companies can be adjusted to account for performance differences relative to the subject com-
pany. Finally, it may also be important to consider market multiples of both healthy companies (adjusted
or unadjusted) and distressed companies when developing a frame of reference from which market mul-
tiples applicable to the subject company can be selected.

Step 2: Normalize Financial Statements

After guideline companies have been identified, it becomes necessary for the valuation analyst to adjust
the financial statements of both the guideline and subject company being valued for comparability pur-
poses. These adjustments are most commonly associated with (1) accounting adjustments (generally ac-
cepted accounting principles [GAAP] adjustments), (2) nonrecurring items, (3) the impact of nonoperat-
ing assets, and (4) off-balance-sheet items.

All normalization adjustments should be made to present the results of the company’s operations in a
manner that conforms with anticipated future operations and informs analysis of prospective future per-
formance. Normalizing adjustments for nonrecurring items are particularly important for distressed
companies. Companies in bankruptcy typically have various nonrecurring expenses associated with the
bankruptcy process itself, such as professional fees and restructuring charges. Moreover, the company is
likely going through a restructuring process that will affect future revenues and expenses. The valuation
analyst should take these restructuring charges into account when normalizing the financial statements.
In addition to the restructuring charges, the valuation analyst should consider normalizing the financial
statements for the operational and financial effects of the restructuring itself. Depending on the purpose

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