COVID-19, Economic Slowdown and the impact on Valuation
As uncertainty surrounding the timeline and ability to manage the spread of COVID-19 grows, so does the complexity of managing and valuing businesses. Social distancing and the reduction or elimination of “non-essential” activity has profoundly disrupted or even closed businesses and supply chains across the United States and globe. There are a number of environmental factors that business owners, their counsel and advisors should be aware of that may affect the value of a privately held business. We’ve summarized some, but not all, of the key issues to consider below:
- Valuation Date – Depending on the objective of the analysis, the date of the valuation may drive the extent to which the COVID-19 pandemic can be considered.
- Valuations performed under most income tax and financial reporting standards require valuations to consider only facts and circumstances “known or knowable” as of the valuation date.
- Valuations performed as of a specific date in early 2020 are complex given the “known or knowable” standard combined with a constantly changing news cycle and varying public expectations surrounding containment of COVID-19.
- Use of Historical Financial Results and Management Projections – For many companies, historical financial results from before March 2020 are suddenly less relevant to a valuation of the business during this period. Conversely, preparing projections of future results during this unprecedented period of uncertainty is a challenging exercise. Gleason’s valuation processes includes asking informed, directed questions and considering in-depth valuation issues specific to each business. For example:
- Is the disruption to customer behavior, supply chains or working capital so severe that historical financial results are irrelevant?
- When do management, investors and analysts believe the company and its industry’s operations will resume normalcy, and, to what extent will the “new normal” level of operations compare to historical results?
- Given existing working capital, how long can a company survive and what changes can be made to its cost structure to extend the survival timeline? To what extent does the business have access to short-term funding, including government assistance?
- Have short-term sales been lost, delayed or some combination thereof? Can the company expect a mid-term spike in revenue when economic activity returns?
- What is the lead time between customer orders/demand and the delivery of goods or services? How will a delay in demand effect revenue (positively or negatively) six months, one year or two years down the road?
- What capital spending, research and development and other growth projects must be or can be delayed or cancelled and what effect does this have on the company’s long-term growth rates?
- What is the company’s position within its industry? Is it better or less equipped to handle this upheaval than its competitors? Who will be in the market in the future? Will the behavior of customers permanently change in a way that impacts both the company and the industry?
- How effectively and productively can employees work remotely?
The answers to these key questions and issues will vary on company by company basis. Gleason relies on its experience and expertise to assess responses to these issues and quantify the effect on the value of each specific business.
- Cost of Capital – In general, increased uncertainty results in increased cost of capital (i.e. required rate of return) and, consequently, lower values. Indeed, securities analysts and academics have recently advocated an increase in the cost of capital associated with all publicly traded companies relative to the risk-free rate (this is commonly referred to as the Equity Risk Premium, or “ERP”). The following are business-specific issues that valuation analysts will need to consider to determine a cost of capital for specific companies:
- Is management prepared to effectively guide the business through the issues it faces?
- Is the company able to provide reasonable, reliable projections?
- How has volatility in public markets affected business and industry-specific risk?
- Has the company’s cost of borrowing changed? Does the business have capacity on its current debt facilities?
Gleason’s experience and expertise in assessing and analyzing cost of capital issues provide us with the tools required to consider these issues specific to each business and determine a reasonable, reliable measure of a required rate of return specific to the subject company in every valuation.
- Use of Market Multiples – Careful consideration must be given to the calculation and application of valuation multiples derived from historical (normal) market transactions or public markets. Key considerations for valuation analysts include:
- When applying the market approach in times of uncertainty and market turmoil, it is essential to appropriately match market multiples with subject company results. For example, it is important not to mix and match implied forward valuation multiples and historical financial results for a subject company.
- Depending on specific comparisons of the subject company and the guideline public companies, it may be more appropriate to rely on trailing valuation multiples than forward looking multiples. The valuation analyst will need to understand the extent to which the subject company has reliably revised projections relative to the guideline companies.
COVID19 has increased the complexity of valuations of practically all businesses. Over the past 30 years, Gleason guided clients has assisted its clients in the past through times of extreme volatility, uncertainty, and complexity and is ready to assist you today. Please reach out to one our team members for customized answers to the above questions as they specifically pertain to your business.