Evaluating equity with peer information

By Alistair Jones

SMU Office of Research Governance & Administration – It can be useful to know how other companies that operate in your industry, or a closely related sector, are faring. The insights are known as industry peer information and firms can use it to make better decisions about investment, capital allocation and strategic planning. 

But industry peer information can also play an important role in determining the outcomes of bankruptcy proceedings. This is the focus of a new study co-authored by Bingxu Fang, an Assistant Professor in the School of Accountancy at Singapore Management University (SMU). 

"The research aims to examine whether industry peer information enhances the accuracy of equity valuations for firms emerging from Chapter 11 bankruptcy," Professor Fang says.

Chapter 11 is a provision within the US Bankruptcy Code where, under formal legal procedures, a struggling company is able to continue doing business, gaining much-needed time to reorganise its operation and debts. It can amount to a fresh start. 

"Chapter 11 is important because it allows financially distressed firms to restructure under court supervision and preserve organisational value, which helps protect creditor interests and maximise the value of assets," Professor Fang says.

Although Chapter 11 is a cornerstone of US bankruptcy law, it is not without its critics who cite lengthy delays, high costs and a contradiction in leaving the debtor in possession. Professor Fang's view is more positive.

"Although the debtor retains operational control under Chapter 11, oversight from the court and creditors provides accountability. In recent years, creditors’ control in Chapter 11 has become stronger by providing debtor-in-possession financing to the firm," he says. 

Firms worth saving

Determining whether the expected reorganisational value of a distressed company will be greater than its hypothetical liquidation value is central to a firm re-emerging from the Chapter 11 process, but reaching an accurate valuation is not straightforward.

"Accurately valuing a firm in Chapter 11 is difficult due to high uncertainty in future performance, limited comparable data and conflicting incentives between stakeholders such as equity holders and creditors," Professor Fang says.

Extant studies have documented large differences between court-approved valuations and the market value of reorganised firms’ post-emergence. 

"Court mis-evaluations are relatively common, and the magnitude can be quite substantial. In our research, we find that the median value of court mis-valuation is around 55 percent," Professor Fang says.

Relevant peer information can help address this problem by providing an objective external benchmark that can guide valuation assumptions. 

"The study finds that the use of peer information reduces valuation errors, improves the fairness of equity distribution among claimants and is associated with better post-bankruptcy performance. It also shows that the effectiveness of peer information depends on the firm’s information environment and case-specific factors," Professor Fang says.

Quality information

"[The] usefulness of peer industry information depends on the availability of relevant and reliable peer data, as well as the incentives of different parties involved in the negotiation process," Professor Fang says. 

‘Relevant’ and ‘reliable’ are salient points. So, how did the researchers create a method for obtaining such peer information? 

They began with a sample listing Chapter 11 reorganisations by US public firms during the 2000–2018 period in which the firm successfully emerged as a reorganised publicly listed entity. This provided the researchers with 530 cases.

Further filtering, including the hand-collection of the court-approved valuation of each emerged firm’s newly issued common stock, resulted in a final sample of 135.

Motivated by valuation approaches used in practice, the researchers applied three empirical measures to capture the availability and relevance of industry peer information for valuation of reorganised firms in Chapter 11 bankruptcy.

The first was the synchronicity of earnings among the bankrupt firm and its industry peer firms – that is, the degree of similarity and the economic strength linkage – in  the year prior to Chapter 11 filing. 

The second measure was precedent merger and acquisition (M&A) deals: the number of completed M&A transactions within the bankrupt firm's industry. The researchers contend that prior enterprise valuation exercises involving industry peer firms in the M&A setting serve as an important source of information for valuing the reorganised entity.

The third measure was multiple valuation gap. A valuation multiple measures the wellbeing of a company by comparing two metrics, usually by dividing one by the other. In this case, it was enterprise value and earnings before interest, taxes, depreciation and amortisation within the bankrupt firm's industry.

And how does this approach improve on present peer information selection?

"Our approach in selecting peers relies on industry codes, which is objective and less affected by researchers’ bias," Professor Fang says. "Such an approach can be viewed as a lower bound in the usefulness of industry peer information as practitioners may further consider the similarity in business model or assets." 

Smaller overvaluation

The research suggests that higher peer information quality is associated with smaller overvaluation upon emergence from Chapter 11. The researchers say the effect is statistically significant and economically meaningful: a one-unit increase in overall peer information quality is associated with a decrease in valuation error of between 27 percent and 42 percent.

"One implication of our findings is that valuation errors can be reduced if courts can take better advantage of industry peer information in the valuation exercise. Our findings [also] suggest that courts that are more experienced in bankruptcy proceedings do exhibit lower errors," Professor Fang says. 

"By improving valuation accuracy, peer information helps ensure a fairer distribution of equity and reduces unintended wealth transfers between claimants during the reorganisation process."

And will the research be extended?

"Future extensions of this research may explore the role of peer information in distressed asset sales, and the application of machine learning in selecting comparable firms," Professor Fang says.

"Currently, I am working on a new project that examines the role of accounting information in mergers and acquisitions during Chapter 11, which I believe is becoming increasingly relevant these days but under-explored in the literature." 

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