The rules governing the business valuations have changed significantly since Covid-19, and many of these changes will be permanent as we head into 2021.
Valuations are generally based upon consideration of three principal approaches: namely, the income, market and cost (or asset) approaches. While each of these approaches have their own pros and cons, valuation professionals have been putting much more emphasis on the current Covid-19 environment to the discounted cash flow (DCF) method, a variation of the income approach, given its direct relevance to the entity being valued.
As such, CFOs and other finance executives should consider the following key business valuation challenges as we enter 2021.
- “One size does not fit all:” Not all businesses have been negatively impacted by Covid-19. Consider the specific fundamental facts and conditions of a business affecting its financial condition and operating outlook in its valuation analysis.
- The U.S. economic recession and its recovery are highly uncertain: The magnitude and duration of the U.S. economic recession, triggered in large part by Covid-19, and the eventual recovery, affect the prospects for growth and profitability at both the industry and the individual company levels.
- Emphasis on the DCF approach to value: The DCF method has become the method of choice for many business valuations in the new Covid-19 age. DCF analysis requires significant judgement on the part of the valuation specialist in conjunction with management perspectives as to the company’s long-term outlook.
- Higher discount rates in the Covid-19 era adversely impact business values: The risks and uncertainty of businesses are very much heightened, which in turn affects the risk profile of a given company and its business valuation.
- The weighted average cost of capital (the “WACC”) is trending higher: The WACC represents the “discount rate” used to convert prospective cash flow, at the invested capital level, to its net present value equivalent basis. Many of the underlying market-derived WACC inputs have risen of late reflecting the greater risks and uncertainty impacts of the Covid-19 era.
- Risk and uncertainty must align with the company’s outlook and operating projections: If the cash flow of a company has already been tempered to fully reflect Covid-19-related impacts over the long term, then the selection of a discount rate must be developed commensurate to that forecast risk.
- Forward-looking public company market multiples are emphasized: Recent financial history of a company (its past revenue, earnings, cash flow, etc.) are now viewed as less reliable parameters used to indicate value, since they do not fully reflect the subject company’s post-Covid-19 financial conditions and earning power outlook.
- Market transactions of non-publicly-traded companies occurring before the Covid-19 era are given little, if any weight, in the valuation process: Business valuation indications derived under the guideline transaction company method (“GTCM”) are generally viewed as less than reliable because the market multiples are often dated, lack adequate detail, and reflect price levels predicated upon pre-Covid-19 earnings and outlook factors.
- The cost (or asset) approach has taken on more significance: This is because in the present Covid-19 age, many businesses have become financially distressed. Today, the cost approach is often used, especially in situations for which a company may be worth more based on the value of its net asset value or in liquidation than as a going concern.
- Higher discounts for lack of marketability: In the present Covid-19 environment, transactions of businesses have decreased significantly. A decrease in market activity and of the pool of interested willing buyers tends to decrease liquidity.
- Rigorous asset impairment testing and recognition procedures will be the new reality: In the Covid-19 age, many businesses have experienced significant structural changes to their operating models resulting in financial instability, which, in turn, may give rise to asset impairment charges of a significant magnitude.
- For many businesses, bankruptcy, restructuring, and reorganization is the new reality: Under Covid-19, and the concurrent economic recessionary environment, businesses may fail and/or be forced to restructure and reorganize. In these instances, businesses and their underlying assets may require independent fair valuations.
Overall, Covid-19 has uprooted the fundamental approach to business valuation and has forced valuation professionals to reassess. As we recover, we can look forward to this dynamic evolving.
This article was originally published on Strategic CFO 360.