May 1, 2020

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ECONOMIC IMPACT OF COVID-19 ON BUSINESS VALUATIONS

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BY ANASTASIA BOURGEOIS

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THE GLOBAL ECONOMIC IMPACT OF COVID-19 IS STILL UNCERTAIN

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Since December 31, 2019, when Wuhan, China, first reported dozens of patients treated for severe pneumonia of unknown cause, COVID-19 has caused an unprecedented global crisis all over the world.  The outbreak was declared a Public Health Emergency of International Concern on 30 January, 2020, and since then many nations around the world have been working relentlessly to protect the health and safety of all people. The global economic impact of the Coronavirus pandemic is uncertain as it is not yet fully known how quickly the virus could be contained, which additional steps governments will take to contain it, and how much economic support governments will be deploying to limit the human and economic impact of the COVID-19 pandemic.  What is certain however is that uncertainty will be part of the foreseeable future as we all continue to adjust to the new norm.

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BUSINESS VALUATION PROFESSIONALS CONSIDER CHALLENGING QUESTIONS 

 

In response to the COVID-19 Public Health Emergency, business valuation professionals began assessing what this pandemic and its ultimate impact may mean for business valuations.  Professional business appraisers are used to dealing with uncertainty that comes from external factors such as economic and market conditions, political events, regulatory changes, natural disasters and even outbreaks of illnesses, but accessing the impact of COVID-19 is very challenging as we still have limited understanding about how this virus can be contained and what its ultimate impact may be.

 

Over the next few months business valuation experts performing business valuations with valuation dates on or after December 31, 2019, will be challenged to consider the following questions.

 

1.                   What Was Known or Knowable on the Valuation Date?

 

A professional business valuation is performed for a specific valuation date which must be explicitly expressed in the valuation report.  The valuation date is a specific date at which the valuation analyst estimates the value of the business or interest in the business.  Generally, professional standards require that the business valuation expert should consider only circumstances existing at the valuation date and events occurring up to the valuation date.  In other words, a business valuation accounts only for what was “known or knowable” as of the valuation date.  However, an event or a condition may occur subsequent to the valuation date that could affect the value, and such an occurrence is referred to as a subsequent event.  Typically, the valuation would not be updated to reflect those events or conditions and the valuation report would not include a discussion of those events or conditions. 

 

2.                   Should There Be a Disclosure of Significant Subsequent Events?

 

In accordance with the Professional Standards of the National Association of Certified Valuators and Analysts (NACVA) released on June 1, 2011, a professional valuation report may include a disclosure and consideration of subsequent events.  At the option of the business appraiser, in situations in which a valuation is meaningful to the intended user beyond the valuation date, the events may be of such nature and significance as to warrant disclosure in a separate section of the report summarizing the events and assessing their potential impact in the value opinion.  Such disclosure should clearly indicate that information regarding the events is provided for informational purposes only and does not affect the determination of value as of the specified valuation date.

 

The difficulty in assessing the impact of COVID-19 is that there is no definitive date when the “event” took place or “conditions” arose. Unlike 9/11, which happened in the blink of an eye, the conditions surrounding COVID-19 have evolved over several months. The challenge for a business valuation professional is to determine, for a particular valuation date, whether the economic impact of COVID-19 was known or knowable on that date or whether it is a “subsequent event” that should be considered in calculating value.  If it was not “known or knowable,” then it is important to also consider the purpose of the valuation and the equity of either including or excluding COVID-19 impacts. In general, courts prefer to see real-world events (such as COVID-19) incorporated into valuations.

 

The following is a summary of COVID-19 related events as they happened.

 

12/1/2019 - The first case of COVID-19 occurred in China around this date.

12/31/2019  -  The first time China reported to the WHO Country Office a cluster of pneumonia cases of unknown cause in Wuhan.

1/9/2020  - Chinese authorities identified a novel coronavirus and reported 59 cases.  1/11/2020 - China’s state media reported the first death.

1/21/2020 - The first confirmed case of COVID-19 was reported in the U.S.

End of Jan 2020 - Almost 10,000 cases  and more than 200 deaths had been reported in at least 21 countries.

1/31/2020 - The U.S. government declared a public health emergency and issued new restrictions on travel into the U.S. by persons who may pose a risk of transmitting COVID-19.

 

Most valuation experts believe that as of December 31, 2019, COVID-19’s impact was not known or knowable, and the impact became known or knowable at a later date, such as January 31, 2020, when the U.S. declared a public health emergency, or even late February or early March 2020, when the U.S. stock markets first began to react to the threat. 

 

In summary, for valuation dates from December 31, 2019 until the end of first quarter of 2020, business valuation professionals will have to use their professional judgment and consider the valuation purpose, statute, and court jurisdiction specific issues related to a specific valuation engagement in order to assess and formulate the impact and disclosure of subsequent events related to COVID-19.

 

3.                   Will the Business Continue Operations?

 

When performing a business valuation professional business appraiser should consider the company’s historical and expected cash balance, cash flows and the business’s ability to continue operations, especially in light of the COVID-19 impact on businesses.  A valuator must assess adjustments the company has made to preserve capital during this time period and going forward.  The goal of a business valuation expert is to make a determination about how long the company may survive under the current economic situation and what are the company’s longer-term prospects.  This assessment, along with other factors, will determine the most appropriate premise of value, which is an assumption regarding the most likely set of transactional circumstances that may be applicable to the valuation.

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If the company is not contemplating liquidation and the business valuation professional determines that the company is expected to operate into the future, the company will be valued based on the going concern premise, which is the most common premise of value used in professional business valuations.   If a liquidation is imminent, an orderly or forced liquidation premise will be used which assumes that the business is terminated and the assets are sold piecemeal.

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4.                   What Are the Most Appropriate Valuation Approaches in the Midst of COVID-19?

 

Business valuation professionals typically consider three approaches to value a business - the asset, market and income approaches - and rely on one or two to determine the value of a business depending on the specifics of the valuation.  The economic conditions created by COVID-19 make some approaches potentially more relevant than others.

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Let’s take a look at the income approach and discuss why in the upcoming weeks and months the Discounted Cash Flow method under the income approach may be a more relevant method to determine the value of a business in light of the negative economic impact of COVID-19. 

 

Income Approach

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The income valuation approach bases the value of a business on its ability to generate future economic benefits.  This valuation approach estimates the value of a closely held business by converting business’s future expected cash flows or earnings into a single present value.  The income valuation approach is generally most appropriate to value established, profitable companies.  Two main calculation methods are utilized within the income approach, the Discounted Cash Flow method and the Capitalization of Cash Flows method.

 

The Discounted Cash Flow method entails estimating the future cash flow streams of the business and adjusting them to reflect the time value of money and associated business and economic risks.  The Discounted Cash Flow method is typically used when future expected cash flows or growth rates are expected to vary over a certain period of time.  Business appraisers project the company’s future financial performance for each year over a certain forecast period (usually five years) and estimate the value of a business after the forecast period when the business is expected to grow at a set growth rate in perpetuity.  The Discounted Cash Flow method is a meaningful method when trying to estimate the future performance of a business affected by the COVID-19 pandemic as the business stabilizes and returns to a “normal” level of operations and profitability over time.

 

The Capitalization of Cash Flows method within the income approach is most appropriate when a company’s historical earnings can reasonably be considered indicative of its future operations, and is best applied when valuing mature companies with steady earnings.  In light of the COVID-19 economic impact business valuation experts may find it challenging to justify the use of stable earnings projections and steady long-term growth rate going forward.  Thus, this method currently appears to be less relevant than the Discounted Cash Flow method when estimating the value of a business affected by COVID-19.

 

Thus, for the foreseeable future due to the current economic uncertainty and market disruption business appraisers should choose to utilize the Discounted Cash Flow method and forgo the Capitalization of Cash Flows method until businesses return to their usual levels of revenue and profitability.  This is true for businesses affected both negatively and positively by the COVID-19 pandemic. While businesses in some industries, such as retail, transportation and travel, have been seeing an formidable negative economic impact of the CODVID-19 pandemic, businesses in other industries, such as grocery delivery services, manufacturing of personal protective equipment, critical infrastructure construction and repairs, as well as healthcare and technology industries that offer opportunities for remote work, have been seeing their revenues increase or remain unchanged.

 

The remaining two valuation approaches described below, although still valid, would require careful considerations and additional adjustments to be made when calculating the value of a business affected by COVID-19.

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Market Approach

 

Using the market approach, business valuation professionals base the value of the company on how similar companies were priced in the market in the past.  Business appraisers aim to locate comparable businesses that are traded on a public market, or entire companies that have been sold. Based on the identified transactions appropriate pricing multiples are calculated, such as price to revenue or price to earnings, and applied to the revenue or earnings of a business being valued.  Typically, this valuation approach is particularly useful when valuing public companies or privately held companies large enough to consider going public because data on comparable public businesses is readily available.  This approach is difficult to use for relatively small, privately held businesses because comparable companies may be scarce, and reliable information is difficult to obtain.

 

The use of the market approach amidst COVID-19 in especially challenging, and a straightforward calculation of an average of market transaction multiples based on a pre-COVID-19 transactions will not suffice.   In the near future this method may require more analysis and adjustments before using pre-COVID-19 market transactions in post-COVID-19 valuations.  Due to the current unpredictability of the current environment adjustments to transaction multiples related to COVID-19 may rely more on professional judgment than empirical evidence, aiming to capture the current market’s perspective on the value of businesses as of the valuation date.

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Asset Approach

 

The asset approach derives value from the combined fair market value of the business’s net assets. Under this method, all tangible and intangible assets of the business are identified and adjusted from book value to fair market value, and then reduced by the fair market value of all liabilities.  The assets-based method is an appropriate method for estimating the value of a non-operating business such as a holding company, when losses are continually generated, when the company's net value based on income or cash flow is lower than its net asset value, or when liquidation is imminent.  Due to the current market volatility and economic uncertainty business valuation professionals here too should apply additional considerations and adjustments to the fair market value measurements.  Specifically, assumptions may need to be made as of the valuation date about the likelihood of orderly transactions or distress/liquidation sales to take place, which assumptions the market participants are likely to use, what are the principal and most beneficial markets for assets, and what is the highest and best use of certain nonfinancial assets amidst COVID-19.

 

Overall, the economic impact of COVID-19 permeated every aspect of the business valuation profession and professional valuators are doing their best to consider the uncertainty of the current environment, evaluate key elements that require more emphasis than a typical valuation, and use their professional judgment to decide how best to incorporate the economic impact of the COVID-19 pandemic in the business valuations with valuation date on or after December 31, 2019.

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Bibliography

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National Association of Certified Valuators and Analyst, NACVA (2015). Professional Standards.  Retrieved from: http://web.nacva.com/TL-Website/PDF/NACVA_Professional_Standards_Incl_Review_Stnds_Effective_8-1-15_Final.pdf

 

National Association of Certified Valuators and Analyst, NACVA (2020). The Value Examiner.  Retrieved from: http://s3.amazonaws.com/web.nacva.com/TL-Website/Value_Examiner/2020/20-MA-A.pdf

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