6 May 2020
The COVID-19 pandemic has spread rapidly to create both a global health and economic crisis, the latter notably via a significant decline in share markets, widening of credit spreads and increased stock volatility. The ultimate extent, reach and duration of the global effect are unprecedented.
Whilst we are all individually adjusting and grappling with the impact of COVID-19 on our personal, family, health and professional environments, businesses have also been forced to reconsider strategies to navigate through these uncertain times.
Despite the current uncertainty, boards, CFOs and others will still be required to make sound decisions regarding value in order to consider:
- Potential capital allocation.
- Restructuring activity.
- Share swaps and transfers.
- Pricing and assessment of potential transactions.
- Comply with financial reporting requirements.
- Impairment testing.
- Meeting taxation obligations.
Here are some of the inter-related factors you should consider and analyse when undertaking valuations in the current environment.
Reliability of valuation methodology and validity of underlying inputs
Valuation methodologies generally fall under one of three approaches along with their application in the current environment:
1. Income Approach
Primarily applied via a Discounted Cash Flow (DCF) method – under this approach the value of an asset is based on the cash flows the asset can be expected to generate in the future. Typically, the prospective future performance is assessed over multiple future periods.
Application - given the significant and rapid changes currently taking place in the economy and varying impact on prospects for industries and individual entities, past results are not likely to be an accurate predictor of future outcomes. Thus, a range of plausible future development scenarios may need to be explored. Accordingly, the DCF methodology is likely to be the most relevant valuation technique to apply in the current environment.
This methodology allows entities to capture the impact of the current situation, the timing of recovery/ramp-up and full consideration of the future cash flow profile as the wider economy and the business exits the COVID-19 environment and returns to a steady state.
2. The Market Approach
Under this approach the estimates of value are derived by reference to market prices in actual transactions and asking prices of assets currently available for sale.
Primarily applied via a Capitalisation of Future Maintainable Earnings (CFME) method - the estimates of asset value are based on the income the asset can be expected to generate in the future by referencing recent past performance and can be supplemented by immediate future performance expectations. Thus, the focus under this method is largely on the current performance.
Application - given that in the current environment earnings are unlikely to reflect a “normal” or steady state of operations, the application of a CFME method is challenging. CFME method is unlikely to yield accurate outcomes (as a primary valuation approach), however would be more applicable to employ as a cross-check. However, it is important to ensure adequate understanding of the assumptions in respect of required return, growth prospects, risk, and other factors implicit in these metrics.
Further, historical inputs are unlikely to be reliable and their use in a current COVID-19 pandemic environment valuation analysis may be inappropriate, for instance:
- Earnings multiples based on past transactions will be reflective of prior data, historical market conditions and outdated market participant assessments. Relying on historical multiples reflecting financial information or transactions that do not incorporate the earnings and growth impacts of the COVID-19 pandemic are unlikely to be representative of market participants’ current views.
- Forward earnings multiples implied from the share trading of listed companies and earnings forecasts may not have been updated to incorporate the impact of the COVID-19 pandemic. Therefore, forward earnings multiples may not be representative of expected outcomes or market participant assumptions. In particular, a number of companies and research analysts have either not updated earnings estimates (or withdrew them) due to the significant uncertainty in forecasting in the current environment.
- Earnings forecasts prior to the COVID-19 pandemic will not accurately capture the businesses growth prospects and risk as at the current date.
The Market Approach can also be applied using comparison of the subject to be valued to a directly comparable entity (typically involved in a recent transaction). Consequently, it’s important for there to be direct similarity between the subject entity/asset and other similar entities/assets. Direct similar comparisons are typically difficult and will be vastly more challenging (likely impossible) to identify in the current environment.
3. The Cost Approach
Under the Cost Approach the estimates of asset values are derived using the concept of replacement cost. It is based on the premise that a prudent investor would pay no more for an asset than the amount for which the asset could be replaced. In applying the cost-based approach in the context of business valuations, the value of the subject assets can be determined on the basis of going concern, orderly realisation or liquidation.
Application - the harsh reality for some entities is that the impact of the COVID-19 pandemic on cash flow forecasts and the application of a DCF method may yield valuation outcomes that are less than the value of the net assets of the business.
Conceptually, the value of an entity should not be less than the value of its net assets under an appropriate realisation basis (i.e. going concern, orderly realisation or liquidation). In circumstances where the value of an entity under the Income/Market Approach is lower than the net asset position, it would typically be appropriate adopt an asset-based methodology as the primary indicator of the current value of the entity provided that the reasons for the difference in the valuation have been investigated, understood and accounted for.
The application of a net assets approach will necessarily need to include the consideration of a reasonable value for each asset and liability recorded on the statement of financial position of the business. Consideration of adjustments to each asset class will be required to produce valid valuation outcomes under this approach.
In general, if applied correctly, any combination of valuation approaches should yield similar values. However, discrepancies are not uncommon and the reasons for variance need to be investigated and understood. For example, if a DCF yields a lower value than the net assets of the business, it may well be the case that the assets of the business are impaired as the DCF indicates potential economic obsolescence of the assets.
Future cash flows
As noted above, a DCF methodology is likely to be the most reliable valuation technique to apply in the current environment. Application of the DCF methodology involves adopting a set of cash flow forecasts (usually for a minimum period of three to five years), calculating terminal year value of the cash flows beyond the forecast period and discounting the forecast cash flows and terminal value at an appropriate discount rate to calculate the present value.
At any time, forecasting future cash flows is challenging. However, in the current economic landscape, determining a realistic and reliable set of cash flow forecasts is even more difficult. Very few, if any, businesses are likely to have cash flows and earnings unimpacted by the COVID-19 pandemic. For some the impact may be short-term, whereas others may experience a prolonged effect over a longer period until the entity could be expected to return to stable cash flows, if it survives.
Broadly, the prevailing view globally is that, as in past economic downturns, a recovery period will follow. A key overarching consideration will be the profile and timing of the eventual global and local economic recovery, and potential change in consumer behaviour for some sectors, which will be an important value driver.
The assumed timing in the recovery trajectory could vary up to two years. McKinsey’s worst-case scenario envisages the world economy returning to pre-crisis growth in Q3 2022 . In reality, no one can accurately predict the correct scenario, but it’s necessary to take a pragmatic view and consider at least a best case and worst-case scenarios.
Further, a number of entity specific factors must be considered when developing a reliable set of expected future cash flow forecasts. Forecast cash flows will be the primary driver underpinning current valuations and must necessarily incorporate:
- Expected revenue growth trajectory.
- A revised view of gross profit and earnings margins that may be achievable in the foreseeable future.
- Critical review and analysis around the cost structure.
- The timing and quantum of business capital expenditure.
- Re-evaluation of prospects and opportunities.
- Immediate working capital requirements.
The response to containing the pandemic has been the introduction of a number of measures, which will have consequential impacts on consumer demand, supply chains and economic growth for the near-term. The financial impacts on businesses are wide ranging and will vary significantly across sectors and for individual entities. Further, the timeframe and profile of expected economic recovery will vary and be influenced by:
- Sensitivity and elasticity to the economic environment.
- Inter-related impact upon aspects of the supply chain.
- Short-term versus prolonged shut-downs.
- Changes in customer behaviour and demand (positive or negative impact).
- Competitive position.
- Access to capital (including access to government stimulus).
- The ability to access labour and other resources when required.
All of the above need to be adequately considered and factored into cash flow forecasts.
Risk and reward/return
As discussed above, the DCF methodology requires the determination of future cash flows and an appropriate discount rate. It is important to match the discount rate with the cash flows adopted to calculate either an enterprise value or an equity value. In addition, it is important to ensure consistency between the risk factors inherent in the cash flows and the risk factors accounted for in the discount rate – there should be no double-counting of the same risk factors in the cash flows and the discount rate.
In times of economic uncertainty and volatility, investors often re-allocate funds to cash or other low-risk asset classes as a protection mechanism. The consequences of this re-allocation lead to prices for ‘riskier’ investments such as shares and corporate debt instruments to decrease as investors seek higher returns for the additional risk. These higher risk premiums are also sought by offerors to attract investment. The outcome is the cost of equity and debt has increased for most market participants:
- Equity - in an attempt to mitigate the longer-term economic impact of COVID-19, Australia has taken wide-ranging fiscal measures to protect businesses and offers social welfare assistance. The funding of these policies will likely create fiscal deficits for the foreseeable future, therefore causing re-assessment of the credit risk of sovereign credit. For example, in March 2020, when the Australian federal government announced significant stimulus packages, the yield to maturity on Australian Government ten-year bonds (a risk-free benchmark) increased from 0.60 percent on 9 March to 0.77 percent by 31 March 2020 and was sitting at 0.86 percent as at 21 April 2020; and
- Debt – the yields on debt instruments have increased sharply, particularly for non-investment grade instruments, which bear higher risk. In addition, the spread between investment grade and non-investment grade instruments has also widened.
Estimating future cash flows in the current environment is extremely difficult and subjective. A number of listed companies have withdrawn earnings estimates and many sell-side analysts have yet to update their earnings projections. To the extent that the risk factors are not accounted for in the forecast cash flows, an additional specific risk premium (or ‘alpha’) may need to be included into the discount rate.
Whilst it is more reliable to adjust the earnings or cash flow projections to explicitly cater for specific risk factors, in the current circumstances it may not be practical to attempt to quantify the full impact in the cash flows alone.
Further an adjustment for illiquidity may also be required if it is observed that the marketplace for buying and selling assets has ceased, or its efficiency has significantly diminished. This would translate to a higher required rate of return. An illiquidity adjustment is different to the alpha adjustment noted above and should be separately considered.
Price and market value divide
Market value represents the fair market value that a pool of hypothetical purchasers may be expected to or willing to pay in exchange for an asset. Price is the outcome of a sales process agreed between the parties during transaction negotiations. The views on the price and value may differ depending on the circumstances. As Warren Buffet once said: “Price is what you pay, value is what you get.”
Consequently, ‘value’ and ‘price’ may differ. In uncertain times investment decisions are not always based on rational considerations and momentum may dominate fundamentals. In addition, investors may put more weight on short-term situational factors, and may not have sufficient regard to longer-term prospects. This contributes to the rapid decline in global share markets, as new (negative) information is circulated during the pandemic.
The opposite may be true for entities that experience an upturn in activity due to the COVID-19 pandemic (e.g., manufacture of medical products). In relation to negatively impacted entities, it may be possible for opportunistic sales to occur (i.e., distressed, low liquidity or undesirable assets and business entities), therefore resulting in the achievement of prices lower than market value otherwise could be. In particular, recent significant fundraising by private equity, infrastructure and other funds means there is global uninvested capital for potential allocation . Consequently, adequate diligence on the pricing of any transaction is even more critical in the current environment.
As highlighted above, the rigour required around the valuation process has increased, particularly in the application of the DCF method, assessing discount rates and determining projected earnings and cash flows. Determining an accurate valuation is complex, and many critical issues are often overlooked, particularly in the current COVID-19 landscape. This leads to greater subjectivity and more divergence in opinions of value amongst market participants. Therefore, it is critical that qualified valuation practitioners are engaged to assist in navigating these complex valuation issues.
Further, impairment testing in the current environment will be high on the agenda for boards, auditors and regulators. The required level of rigour around cash flow forecasts, consideration of potential scenarios and assessment of discount rates will have significantly increased from prior periods and the complexity associated with fully addressing and incorporating all influencing factors should not be underestimated.
Our skilled team has extensive Corporate Finance experience across a wide range of sectors. The key to our involvement is adopting an integrated approach. We understand that value is driven by risk and return, and that perceptions about each can vary. Each business is unique, each has different underlying factors that drive, and impact value and each business will bear vastly different impact and path to recovery in response to the COVID-19 pandemic.
If you require assistance with valuation advice or impairment testing considerations for your 30 June 2020 analysis, please get in touch with the Findex Corporate Advisory team today.
 As at 31 December 2019, the global private equity sector had $1.5 trillion in uninvested capital (Preqin).