Tanvi Pahwa*

With the recent outbreak of COVID-19, stock markets around the world have plummeted with the SENSEX falling by over 40% since the beginning of March. In valuation parlance, volatility is translated as risk and is a key parameter in pricing an asset. However, quantifying such a risk is challenging at this time as the situation is still developing, and there are no clear indications as to when the pandemic will subside.

For most industries, their business operations have been negatively affected by this pandemic. However, there are few industries which have also been positively impacted namely online education, platforms like zoom, pharma companies.

Valuation

In the following section, we have discussed the effects on valuation approach (most used approach i.e income approach and market approach) in detail and few considerations that the valuation professionals may need to undertake while finalising their valuation reports:

COVID 19 Consideration: Income Approach

The income approach of business valuation is based on the idea of valuing the present value of future benefits. This approach estimates business value by considering the future income accruing over a period of time. There are two major methods that fall under this category which is capitalisation of earning method and discounted cash flow method. Thus, we need to assess the following considerations while using the Income approach:

  • Reduced cash flow assumptions due to uncertainty of risk
  • Sensitivity and Scenario Analysis
  • Increase in cost of capital
  • Assessing whether there will be a V shape recovery or a U shape

Let us have a look in detail of the effects on these considerations:

Cash Flow Projections:

Valuation using Cash flows is a method of estimating current value of a company based on projected future cash flows adjusted for time value and money. The cash flow of a company depends on the revenues generated by the company minus expenses.

The cash flow of the companies might be adversely affected because of the current situation. 2020 revenue and expenses may reflect significant fluctuations from historical trends and may not reflect a normalized level of operations for the basis of forecasting a subject entity’s cash flow. Therefore, valuators may have to be acutely aware of the need to make normalizing adjustments to both revenue and expenses as part of their forecast models. Some of the issues that the company may face and adjustment would be required to be made in forecast are following:

√ Changing customer behaviour

√ Short-term and long-term impact on revenue

√ Labour shortages

√ Increased cost of production

√ Increase in working capital days

√ Impact on short term liquidity

√ Difficulty in meeting debt obligation

Having said so, it is also important to know that not all business would be negatively impacted and depending on the specific entity type, these adjustments may need to be done.

Discount Rates

The capital assets pricing model (CAPM) is a widely adopted fundamental model to derive the rate of return on equity investment or also known as the cost of equity. In an enterprise valuation, the cost of equity is combined with the borrowing rates or the cost of debt, in accordance with the enterprise’s capital structure, to form the weighted average cost of capital (WACC). The WACC will then be used to discount the projected cash flows to present values.

However, at least in the short term, the CAPM appears to be insufficient to fully reflect the additional risk brought by the COVID-19 outbreak given its non-diversifiable nature. In addition to the size premium and company-specific premium which are typically added to the cost of equity in the CAPM approach, a risk premium for COVID-19 may be worth considering. Thus, it may lead to an increase in cost of capital.

In case the cash flows are already adjusted with the effects of COVID 19, no further adjustments would be required in the discounted rate

Discount for lack of Marketability:

According to Valuing a Business: The Analysis and Appraisal of Closely Held Companies, the typical definition of marketability is “the ability to quickly convert property to cash at minimal cost with a high degree of certainty of realizing the anticipated amount of proceeds.”

The International Glossary of Business Valuation Terms defines a discount for marketability (DLOM) as “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.”

Since volatility is a factor in discounts for lack of marketability, the extreme volatility of the market in recent weeks may materially increase DLOMs. In addition, it should further be adjusted for the for the abnormal conditions in the market which may necessarily cause buyers to be reluctant to invest in illiquid fund.

The valuator should use his own professional judgment while using DLOMs.

Sensitivity Analysis

Fair value is based on what is known and knowable at the time of valuation and it requires informed judgement. Thus, while valuing companies for the year 2020, revenue and expenses may show a significant fluctuation from historical trends and may not reflect a normal level of operations for the basis of forecasting entity’s operation. Thus, while computing the fair value, sensitivity and scenario analysis might be worth considering. 

COVID 19 Consideration:  Market Approach

Market Approach refers to the notion of arriving at the value of a company by comparing it to the market value of similar publicly listed companies. In the recent environment, market capitalisation has declined across various sectors.

Thus, we need to assess the following considerations while using the market approach:

  • Evaluation of maintainable revenue and earnings, keeping in view the market participants perspective
  • Assessing whether recent transactions are still comparable
  • Assessing whether current market multiples reflecting long term fair value

Below we have discussed how the multiplier approach of valuation would be impacted in the current scenario.

Multiplier approach

The multiplier approach is a comparable analysis method that seeks to value similar companies using the same financial metrics. Market approach requires use of different multiples like Book Value Multiple, EBIT multiple etc. A multiple reported even a month ago might materially misrepresent the risk associated with a comparable transaction today.

Thus, the valuation professional need to carefully use the multiples associated with the transactions that occurred during this crisis.

Conclusion

These are some of the common areas of valuation which can be affected because of the current global crisis. However, there is no set approach to account for market uncertainties as the impact might be different for different business in different region. Thus, the businesses which were valued as on 31st December 2019 would reflect a different picture as against valued on 31st March 2020. It will be important to discuss and assess any near- or long-term effects in financial performance with the management. The Valuator need to apply their professional judgement on case to case basis.

The traditional approaches to valuation need to be carefully reconsidered in the current environment. Valuators will need to conduct a more rigorous due diligence on the quality of financial forecasts provided to them and what adjustments, if any, should be made to earnings, multiples or discount rates.  Thus, implication and challenges to the valuation would be unique and the and negotiating the valuation to close a deal would remain a challenge.

*(Author Tanvi Pahwa is Assistant Manager with with International Business Advisors, Delhi)

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