The impact of COVID-19 on business valuation
by Matthew Byford, CFA, ASA, CFE, and Jason Buhlinger, CPA, CFE, CVA
COVID-19 and the resulting crisis has created significant volatility in the financial markets since late February. Although we’re no longer seeing large daily (5%+) fluctuations in the U.S. public equity markets, market experts and fund managers are divided in their expectations of the speed and strength of recovery once COVID-19 is tamed. The bulls and bears can only agree that the current economic landscape looks wildly different from the end of 2019.
Uncertainty is dominating the news cycle, and many companies have withdrawn earnings guidance until further notice. Volatility is the market’s expression of risk and uncertainty. However, quantifying COVID-19’s impact is more complex than just an increase in the discount rate. How will COVID-19 affect valuations of your clients’ businesses? The answer is one commonly provided by valuation experts: it depends. Below is a compilation of our thoughts on the effects of COVID-19 on business valuation.
Company-specific risk premiums should be modified to consider the effect of COVID-19
Valuation analysts typically adjust for company-specific risk when developing a discount rate. Much of the market data commonly used summarizes approximately 100 years of public market data and therefore does not contemplate the immediate effect of a worldwide pandemic. We believe the company-specific risk premium should be adjusted to capture the additional risk facing a company until conditions return to normal. The quantification of COVID-19 risk will ultimately be a valuator’s judgment.
We wouldn’t expect a COVID-19 adjustment to the company-specific risk premium to be a consistent adjustment applied evenly to all companies. The severity of COVID-19’s impact will vary widely, depending on a company’s industry, location, service offerings, flexibility and debt level, among numerous other factors. Discussions with management are key to determining COVID-19’s impact on a business. Customers may disappear or supply chains may be disrupted. A janitorial or cleaning service may be largely unaffected, but car dealerships, restaurants, and brick and mortar retail stores are currently fighting to survive. Commercial and residential property owners may not receive rent payments from tenants or may be forced to re-structure their leases. The duration of the impact will also likely vary. Long-term demand may drop for office space as businesses explore telecommuting as a cost saver. Restaurants, especially popular ones, may quickly bounce back once restrictions are lifted. Other industries may see slow sales for years as job losses mount and households cut spending. Valuation experts must think critically through the severity and duration of potential cash flow impacts in order to assess the risk to each specific company.
History will be a poor indicator of future cash flows
In certain circumstances, it is common for valuation analysts to rely on a one-period capitalization of cash flow model. The limitations of a capitalization of cash flow model will be highlighted during this crisis. The one-period model often uses some combination of historical performance to estimate a “normalized” year’s performance. It then assumes that this “normalized” performance continues into perpetuity. However, this crisis will leave very few companies unchanged. 2020 will not be normal and certainly won’t look like 2019. A weighted average of a business’s historical performance will likely not represent cash flow expectations for 2020. At the same time, the suppressed demand caused by social distancing regulations are expected to be temporary and will not continue into perpetuity.1 A one-period model doesn’t give valuation analysts enough tools to accurately capture expected effects of COVID-19 over the next few years.
The discounted cash flow model is the solution
A multi-period discounted cash flow (DCF) model allows valuation analysts to get more granular by using annual projections several years into the future. We believe a DCF model is necessary to capture the expected temporary nature of this crisis. Ideally, a valuation analyst would gather base case, downside and upside scenarios and apply probability weights to each scenario. After all, a vaccine or other solution could come to market that quickly restores economic activity to 2019 levels. Unfortunately, small, less-sophisticated companies often struggle to provide reliable projections. Also, divorce courts seem to prefer the capitalization of cash flow model to a DCF model. We recommend using a discounted cash flow model whenever possible.
Valuation date is critical
A December 31, 2019, valuation date will not and should not capture any coronavirus downside due to what was known or knowable at that time. Depending on the facts of a specific case, the valuation date may need to roll forward to capture current market conditions. Much consideration must be given to when the economic impact of COVID-19 and social distancing was known or knowable to a hypothetical buyer. The World Health Organization did not declare the outbreak a Public Health Emergency of International Concern until January 30, 2020. The S&P500 reached its all-time high on February 19, 2020. By the end of March, most of the United States was under virtual lockdown.
As of the date of this article, some states have begun to loosen restrictions and reintroduce normal economic activity; however, regulations and guidance are changing daily. Should the circumstances of a case require an accurate valuation as of the date of trial, supplements or revisions to existing valuations may be necessary to capture the current position of a company. When the circumstances of a case require a valuation date in February 2020 or March 2020, expect COVID-19 and the known or knowable principle to be a significant issue.
We will see higher valuation discounts
S&P Global Market Intelligence reported 1,015 sale transactions in January 2020 and only 341 in March 2020. A decrease in market activity increases illiquidity. In general, it is logical for discounts for lack of marketability to be higher for valuation dates within the crisis period. It would be very difficult to sell a business under this type of uncertainty. Since everyone is staying home, it’s also very hard to market a company or for a buyer to do due diligence. All other things equal, a higher discount for lack of marketability lowers value.
Management interviews become more important
The government has recently provided many stimulus benefits to business owners and employees to help offset the detrimental effects of COVID-19. The first national benefit package was the Families First Coronavirus Response Act, which expanded leave for employees and created payroll tax credits for certain employers. This was followed by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which provided many more benefits, including over $500 billion in potentially forgivable loans to businesses throughout the nation. Additional stimulus packages have also been provided at the state and local level, depending on the location and industry of the business.
The many available stimulus benefits can create an unwieldy combination of financial scenarios. The management interview is crucial for valuation dates during the pandemic period. It is important that, at a minimum, valuation analysts can talk with management to understand:
The type of benefits received by the company
The date(s) the benefits were received
The dollar value of the benefits
How those benefits are expected to be spent
How the benefits are anticipated to affect the company
The facts and circumstances of each business will be different and need to be incorporated to ensure risk and future cash flows can be properly analyzed.
There is no one-size-fits-all approach
COVID-19 has touched each of your client’s businesses in various ways, which renders a cookie cutter approach to quantifying the impact ineffective. We believe the solution is for valuation analysts to return to the basics of business valuation, consider the specific COVID-19 realities at hand and apply them logically to each aspect of a given business.
Matthew Byford, CFA, ASA, CFE, is a manager in the Transaction Advisory and Litigation Support (TALS) Services practice at Brown Smith Wallace. Jason Buhlinger, CPA, CFE, CVA, is a principal in the Transaction Advisory and Litigation Support (TALS) Services practice at Brown Smith Wallace.