The pandemic COVID-19 outbreak and subsequent lockdown has severally affected global economies which have resulted in business disruption, volatility and significant fall in revenue of the companies worldwide. Valuers while doing valuation for financial reporting or other purposes are required to take impact of this significant global event and arrive at fair value after due consideration of various factors affecting the same.
The implications on business valuations centers around current impact faced the uncertainty of the likely future impact of COVID-19 on the business earnings and cash flow generation capabilities. It also had a significant bearing on the recovery from the impact of COVID-19 on businesses. These difficulties are already apparent as we see that the public equity markets are highly volatile. Add to that, a number of announced transactions has been put on hold. Even the fund raising IPOs have been deferred.
Post COVID-19, the valuers have been compelled to make certain adjustments. It goes without saying that they need to carefully reconsider in the current environment. Some pivotal changes which need to be made in adjustment when re-pricing valuations of businesses are:
1. A tweak in timing and growth on projected future cash flows or earnings of the business.
2. An adjustment in cost of equity or discount rate used to discount the projected future cash flows.
3. An adjustment to the policies made to capitalize the earnings.
4. An excess volatility adjustments based on observed market earnings yield.
5. An adjustment over liquidity or marketability discounts.
Adjustments to Future Cash Flows– These are an obvious adjustment that shall be put in place. To factor-in the impact of pandemic COVID-19, Valuer needs to access following points: (a) how deep will the impact be (Hit); (b) how long will the hit survive (Duration) and (c) how frequently do hits occur (Frequency).
- Hit – This could be attributed to the business’ dependency on international trade, products and services provided on the terms which are discretionary, and nature of supply chain etc.
- Duration – At this stage, all is not too accurate to be predicted but the market analysis does show the impact for another 3-18 months. However, afterwards the duration to revive or come back in normal situation could vary due to number of factors including business model, stage of the company and several other internal/external controls.
- Frequency – The situation and its impact is immense and yet rare. This can be corroborated if we look back over the last two decades for an approximation. The occurrence rate needs to be factor-in while valuing event impacted business.
In situations where business is heavily impacted and where the cash flow outcomes are uncertain, the possible scenarios of cash flow outcomes should be modeled and probability weightings need to be applied to those expected cash flow outcomes. Doing this, it can be ensured that the valuation outcomes are not dependent on general assumptions. Generally, it is these assumptions which underpin any particular fixed forecast set of cash flows upon occurrence of possible hits.
Adjustment to Discount Rates– Valuers needs to carefully examine this assumption in the current market. The current volatility in global equity markets only indicates that the risk is still high as far as an investment under the impact COVID-19 pandemic is concerned.
Adjustment to the Multiples in Earning Capitalization Approach– With the changes in the earnings yield of listed companies, an indication can be achieved with regard to the change in cost of equity across the different market sector.
Adjustment of Excess Volatility based on Observed Market Earnings Yield– The level of volatility observed in the market (measured by the VIX index) has nearly doubled since 31st December 2019. In order to translate this into a risk premium, these levels of high volatility might have a short term impact on the cost of equity.
Adjustment over Liquidity or Marketability Discounts– This can be applied at the time of valuing unlisted equities on such events where it is deemed that the investment would take a period of time to sell. Given the current levels of uncertainty and volatility in the global market, there is every bit of possibility that any potential buyer would be hesitant to pay a full fair price. The size of a liquidity discount is impacted by the time over which the asset becomes illiquid, payment of dividends over that period and the level of volatility of the underlying equity
The COVID-19 will have constant impacts on the valuation of businesses in the short to medium term. Hence, the people at the helm of valuation are required to carefully re-consider the traditional approaches of valuation. It is because the current environment calls for an assessment that whether the financials available to them are adequate for the purpose.
This content is meant for information only and should not be considered as an advice or legal opinion, or otherwise. AKGVG & Associates does not intend to advertise its services through this.