For most businesses, and out of necessity, the standard ground rules and playbooks governing the valuation of business enterprises have changed to reflect the new economic realities stemming directly from the COVID-19 pandemic.
Generally speaking, business valuations are based upon consideration of three principle approaches; namely, the income, market, and cost (or asset) approaches. While each of these approaches has their own pros and cons under normal circumstances, valuation professionals tend to give much more emphasis in 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. This method attempts to capture the value of a business by calculating the net present value of cash flow from a set of financial projections of the business enterprise, using an appropriate risk-adjusted discount rate. All this may sound somewhat standard and straight-forward however, “the devil is always in the details.”
Questions arise related to the financial projections of an entity over the next five years. For instance, how much reliance can we place on these estimated projections and the anticipated cash flows? Should we refer to the historical operating performance? How relevant is that historical information in a post-COVID-19 scenario? Will the margins remain the same? How about the cost structure? Will the company be able to access financing at an acceptable cost of funding? What will change in the eyes of the bankers and financiers about the risk perception of this business? Far too many questions to answer and the situation is further complicated when you consider the discount rate.
In addition to the questions and concerns raised above, some key ways in which the business valuation landscape has changed in the current COVID-19 environment are summarized as follows:
- “One size does not fit all": Not all businesses have been negatively impacted by COVID-19. Some have actually experienced phenomenal growth and prosperity. Some have felt mild impacts to operations, whereas others, much more severe effects. Accordingly, the specific fundamental facts and conditions of a business affecting its financial condition and operating outlook must be considered in its valuation analysis.
- The US economic recession and the prospects for its recovery are highly uncertain: Businesses function within the context of the overall US economy and the specific industry in which it operates. The magnitude and duration of the US 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. Hence, these factors of consideration and the extent of any extraordinary and non-recurring impacts are, more than ever, a matter of judgement and concern to most businesses, and they are central in the development of operating projections for the subject company in the COVID-19 era.
- Emphasis on the DCF approach to value: As previously alluded to, the DCF method has become “the method of choice” for many business valuations in the new COVID-19 age. “It’s not business as usual anymore,” and having said that, special care must be taken in the valuation analysis including the use of multiple projection scenario analyses and probability-weighted outcomes. The key in DCF analysis is the development of projections that reflect COVID-19-related impacts, and hopefully, an eventual recovery, to a point of stabilization over the long term. 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. Ultimately, the cash flow projection rationale must be fully documented and consider all relevant economic, industry, and company specific factors, as affected by COVID-19, and as known or knowable as of the valuation date.
- Higher discount rates in the COVID-19 era adversely affect business values: COVID-19 has dramatically upended the overall US economy, many industries (some of whom may never recover), and the financial conditions, prospects, and valuations for many businesses across a broad spectrum. In this current COVID-19 environment, business survival is often at stake and the full magnitude of the adverse impact and eventual recovery is as yet unknown for many, if not most businesses. Accordingly, 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 (WACC) is trending higher for most businesses: The WACC represents the “discount rate” used to convert prospective cash flow, at the invested capital level, to its net present value equivalent basis. For the most part, the WACC is determined based upon market-derived inputs for the underlying cost of debt and cost of equity capital components of a company as of the valuation date. Many of these 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: Risk and uncertainty can be reflected in the cash flow projection itself as well as in the discount rate selection process. These factors are not mutually exclusive; in fact, they are intertwined. Therefore, the valuation analyst must be careful not to double count risk and thereby understate business value. In other words, 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: In the guideline public company method (GPCM), a variation of the market approach, forward-looking multiples are now stressed to indicate business value. This is because, these multiples reflect COVID-19-related market pricing and earnings impacts. The corollary to this, is that the 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), another variation of the market approach, are generally viewed as less than reliable. This is due to the fact that the market multiples derived thereunder 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 in many business valuations: This is because in the present COVID-19 age, many businesses have become financially stressed and the prospect for financial improvement and earning power recovery may be questionable, at best. Under such circumstances, the cost approach is often used, especially in situations in 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 (DLOM) are to be expected in current business valuations: 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 increase illiquidity and the DLOM. Given the cloud of uncertainty hanging over the M&A markets it would be more difficult than usual to sell a business, at least until such time as the COVID-19 pandemic subsides, the economy and markets rebound, and interested buyers regain confidence to undertake deals.
- 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 stress, which, in turn, may give rise to asset impairment charges of a significant magnitude pursuant to ASC Topics 350 and 360.
- For many businesses, the specter of bankruptcy, restructuring, and reorganization is on the rise: Under COVID-19, and the concurrent economic recessionary environment, many businesses may fail and/or be forced to restructure and reorganize. In these instances, and under ASC Topic 852, “Fresh Start” accounting, businesses and their underlying assets may require independent 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.
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