Page 60 - Bankruptcy and Reorganization Services

reaches the long-run growth rate (consistent with the growth rate assumed in the Gordon
growth model). The derivation of this model is outside the scope of this guide.

— Exit-Multiple-Based Approach. A second approach used in estimating a terminal value is
to apply a market multiple to a normalized EBIT or EBITDA in the last year of the pro-
jection period. This market multiple should reflect the practitioner’s best estimate of what
the company would sell for at the end of the projection period. Exit multiples, or "termi-
nal multiples," should reflect expected market multiples at the end of the projection peri-
od. Long-term average market multiples are often used as terminal multiples.

One criticism of this approach is that market multiples based on comparable companies
may reflect expected near-term growth rates of the comparable firms that differ from the
long-term stable growth rate of the subject company. Another criticism of using an exit
multiple is that it commingles the income approach and the market approach. This "mar-
ket approach influence" on the income approach can become more pronounced when
valuing distressed companies, where the terminal value can represent the majority of the
overall value derived from the income approach.

Step 5: Adjust for Ownership Characteristics (Level of Value)

Depending on the nature of the cash flows used in the projections, the income approach can produce ei-
ther a control or minority level of value. Similarly, different assumptions used in the income approach
can produce either a marketable or nonmarketable level of value. If the desired level of value for the
subject interest is different from the indicated level of value, adjustments for control or marketability
may need to be applied (See chapter 7 of this practice aid for discussion of levels of value).

Step 6: Adjust for Discontinued and Nonoperating Assets and Liabilities

The plan of reorganization may specify the elimination and sale of noncore business operations and oth-
er nonoperating assets and liabilities. In addition, some of the debtor’s operations may have been discon-
tinued prior to the plan confirmation phase of the bankruptcy proceeding. To the extent that any discon-
tinued and nonoperating assets and liabilities have been eliminated, the value of such assets and liabili-
ties should be eliminated from the indicated value. In the case of companies in bankruptcy, additional
items that might require adjustment include excess cash, working capital deficiencies, unfunded pension
plan liabilities, and assets held for disposition, among others. Such items will require adjustment to the
balance sheet and may require adjustments to determine normalized earnings on a go-forward basis.

Common Errors in the Income Approach

The following list includes some common errors made by management or third parties when developing
models using the income approach:

 Using nonnormalized earnings in the capitalization method.

 Using the current period cash flow estimate in the capitalization method rather than using the
projected cash flow estimate for the next period as the capitalization base.

 Using a current market multiple in the terminal value calculation rather than the practitioner’s
best estimate of what the company would sell for at the end of the projection period, such as a
long-term expected multiple.

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