The economic and market environment today is characterized by the unprecedented levels of uncertainty brought by the coronavirus disease 2019 (Covid-19) pandemic. Stock markets around the world are experiencing dramatic declines and extreme volatility as investors sell off their equity investments and flee to assets considered safe havens (e.g., gold and government debt). The full extent of the economic and business disruptions, duration of the crisis, time to recover, shape of recovery and possibility of a second wave of Covid-19 infections are still unknown. All these factors have made valuations challenging.
However, significant valuation uncertainty does not necessarily mean that no valuation can be carried out. Valuation specialists should carefully assess and evaluate the inputs to valuations and adjust accordingly to incorporate current market conditions.
Before valuation, a valuation professional should first assess if the business would be valued under a going concern assumption, or distressed or liquidation situation. This assessment will dictate the assumptions and methodologies to be employed. Some factors that must be considered when making this assessment include the industry a company belongs to and the impact of the pandemic on product demand; the effects of evolving consumer behavior and supply-chain disruptions to business operations; the current level of financial leverage and how this influences the company’s ability to raise the necessary capital to continue as a going concern; and the potential breach in debt covenants and default on loan payments, increasing the company’s risk of bankruptcy and liquidation.
Valuations under a going concern assumption
Under an asset-based approach, specifically net asset value (NAV), assets and liabilities are marked-to-market. The following are some areas that should be considered when making this adjustment: adequate provisions for accounts receivable as the risk of customers defaulting on their payments increases; possible inventory write-downs driven by business disruptions; reflect current market conditions on the value of debt and equity investments; and the impact of Covid-19 on properties held.
When applying comparable transaction valuation, one must take care in selecting comparable companies. Similar transactions that are consummated pre-crisis are not comparable to current ones, as market conditions and business outlook have shifted drastically. Consequently, transaction prices pre-pandemic will not represent current fair value without the additional risk and impact of disruptions priced in. Transactions that are otherwise executed during a crisis will require further analysis and assessment of the conditions under which the sale was made to determine if these are orderly transactions. Prices under a forced liquidation or fire sale are not equivalent to fair value in an orderly transaction.
The current environment has magnified the importance of being consistent in applying market multiples in relative valuations. Trailing 12 months (TTM) multiples will appear low, as stock prices are down (numerator) and historical financial metrics do not yet reflect current business disruptions (higher denominator). These multiples may have huge gaps with forward 12 months (FTM) multiples, which are higher, given the expected decrease in business activity (lower denominator).
When applying a market approach, an analysis of stock price movements is warranted, and adjustments to address short-term volatility should be made. Despite the volatility, prices in the market cannot be invalidated, as long as these transactions are done in an active market and in an orderly manner.
Business plans upon which valuations will be based should be updated to reflect the impact of Covid-19 on operations in the short, medium and long term. Some considerations to be made include the effect of the pandemic on distribution channels and consumer demand; the inventory and cost implications of supply-chain disruptions; the interest rate on new loans to be obtained, taking into account quantitative easing measures implemented by central banks and widening credit spreads; and changes in the regulatory framework.
Apart from the immediate effects that the items above would have on the company’s performance, the related impact on working capital, capital expenditure and financing requirements should also be estimated and accounted for. To cope with emerging trends and to capture opportunities uncovered by the pandemic, businesses will need to reassess their strategies and possibly decide to pivot to new business and operating models. Implications on revenue, cost structure and capital requirements should be incorporated in the latest business plans.
As the full impact and duration of the crisis are still unknown, it is prudent to perform scenario analysis and model the related outcomes for each likely scenario. These projections will then be weighted according to their respective probability to come up with an expected value.
In an environment of heightened uncertainty that inherently increases risk, market participants become risk-averse and require higher return rates. To capture this, discount rates are adjusted by incorporating additional risk premia. A company-specific premium or alpha may also be included to account for risk in achieving forecasted cash flows. However, it is preferable to reflect this risk by altering the financial projections. Valuation specialists should be careful not to double-count risk factors by adjusting both cash flows and discount rates.
Valuations under a distressed situation
Businesses under a distressed situation are valued using option-pricing models, essentially valuing equities as options to liquidate, or the expected value approach, which is calculated based on the probability and value under going concern and liquidation assumptions, respectively.
During this uncertain period, valuation professionals should go back to basics. The definition of fair value and the principles underlying valuation have not changed and should still be applied consistently. As the Covid-19 crisis continues to evolve, valuations conducted a few months prior may be irrelevant. It is, therefore, imperative under these conditions to regularly review and reassess valuation assumptions.
Bettina Cheng is a managing consultant of advisory services of P&A Grant Thornton. P&A Grant Thornton is one of the leading audit, tax, advisory and outsourcing firms in the Philippines, with 23 partners and more than 900 staff members. We’d like to hear from you. Tweet us (@GrantThorntonPH), “like” us on Facebook (P&A Grant Thornton) and email your comments to firstname.lastname@example.org or email@example.com. For more information, visit www.grantthornton.com.ph.
As published in The Manila Times, dated 10 June 2020