Valuation during Covid-19 brings a new set of challenges for the valuers and analysts. While assessing the value of businesses, the valuers must keep in mind that while most businesses have been hit negatively, some businesses have benefitted from the pandemic as well.
Some of the key factors impacting business value includes, dependence of business on macro-economic factors; company’s product/service demand; level of technology enablement; the current impact of pandemic on business and the management’s plan towards recovery. Valuers would also need to assess if the management plans towards recovery are plausible.
Unaffected businesses: In case of businesses who have not been impacted by the pandemic and have shown resilience, their valuation should be done as is. In some cases, valuers may assign a higher value for better resilience.
Improved businesses (short term): Think of hospitals, companies that made masks and hand sanitisers. Their businesses skyrocketed in the short run, but they are expected to come down in near future when the pandemic subsides, and these incomes are really extraordinary gains for them. It may be built into valuation as one-time gains. Valuers should be careful while using revenue growth forecasts beyond the next couple of years. Using a high base to calculate revenue forecasts may be dangerous. The likely future cash flow will, at worst, remain where it was pre-pandemic, and possibly increased post pandemic. These companies as a whole have increased in value, albeit marginally.
Improved businesses (long term): Technology enabled companies like Zoom, EdTech companies like Byju’s, ecommerce companies and food delivery companies have really benefitted from the pandemic and expected to continue to sustain the advantages in the medium term. However, valuers must also consider the fact that in the long run, more and more companies may join the party and the margins and revenues of these companies will also come down eventually – normal economics.
Badly affected businesses: Businesses in travel, tourism, restaurants, entertainment businesses have been badly hit and some of them may never recover completely at all. If the company has been severely impacted, assess the going concern impact and assign a probability of the company shutting operations.
Value of the Company = Probability Failure x Liquidation Value + Probability Success x Going Concern Value
Liquidation Value = Current Book Value of the company adjusted for realisability – Shut Down costs
Attention must be given to potential loss of Sales, unrecoverable debt, forced sale of inventory or fixed assets and severance pay to employees.
Going Concern Value
Going Concern Value may be arrived at using scenario analysis. While Scenario analysis is not new and is often used in valuation given the uncertainty around future, this is more relevant during these times
- Base Case: Revenues and Operations may be impacted for 1-2 years and will resume to normal operations.
- Bear Case: Revenues and Operations may be impacted for the next 3-5 years and will take time to recover. Usually, long term projections would be required (say 10 years).
- Bull Case: Revenues and Operations would resume to normal operations within the same / next year.
In case valuers choose to value the company using scenarios, value of going concern may be:
Going Concern Value = Value base x Probability base + Value bear x Probability bear + Value bull x Probability bull
Cash flow considerations
While preparing the projections, care must be taken towards:
- Revenue and Profit Margin levels may be very volatile over the next few years
- Interest rates are likely to be lower in the next few years
- The company’s working capital may change significantly in the short period given the receivables may be delayed and accordingly, the working capital requirements may increase in short run.
- The company’s expansion plans may also be affected significantly during covid. Usually, companies would like to defer their capex plans. However, for those looking to pivot their businesses in a new direction or those positively affected by the pandemic may increase their capex immediately.
- Borrowings may go up in case companies are planning to expand. However, given the lower interest rates, interest expenses are likely to go down.
Discount rate
Since the interest rates are reduced, it calls for a lower cost of capital. Further, investors’ expectations are reduced when it comes to investing given the slowdown in business activity. Since the cost of capital is expected to change considerably over time, valuers may use varying discount rates over time.
The discount rate should be adjusted for Covid only if the valuer is unable to make realistic adjustments in cash flows. Adjusting both cash flows and discount rate may lead to double counting the pandemic effect.
Note that some valuers have followed an approach of adding a discount for distress. Distressed entities generally have higher risk profiles and lower profitability levels compared to their healthy competitors, and a proper discount for distress, usually at least 20%, is built into the valuation. However, this is not a preferred approach and It’s better to build the risk into the cash flows and discount rate.
The COVID-19 marketability discount. Some valuers believe that another way to make a company specific risk adjustment is to add a COVID-19 marketability discount. The controlling interest holder may not be able to sell the interest quickly or with certainty as to the ultimate sales price. After all, under both the income and market methods, the available data really do not reflect increased short-term risk to small and micro business. Market method data are almost exclusively Pre-COVID-19. In many situations, it may make sense to show a separate COVID-19 marketability discount because it clearly shows the valuers’ thought process and the actual discount being applied for the current high level of uncertainty. Clearly, this is a method that would be applied depending on the situation. The logic to develop a COVID-19 marketability discount can be applied to directly adjusting the multiplier, discount, or capitalization rate or applied as a separate discount for marketability. As with any discount, care must be exercised to not apply a discount for a risk that has already been fully accounted for.
When applying a COVID-19 marketability discount, Valuers must value the subject company similar to how they would have prior to COVID-19-related issues becoming prevalent. Valuers may adjust future cash flows to what is most likely. The marketability discount accounts for that increased risk from possible but not predictable economic or governmental action that could change those cash flows.
Use of range and frequent valuations
Valuers must consider giving a range of value for the engagements with a disclaimer that valuations may change significantly and frequently given the changes in circumstances and as situations unfold.