Due to challenges forecasting financial performance and changes to market related valuation inputs the current environment makes it difficult for companies to assess the potential impairment impact on their investments and assets.
The subjective nature of valuations becomes more complex when markets are volatile, and valuation benchmarks quickly go out of date.
Companies must be careful to produce an output that is meaningful and robust with defensible assumptions.
Uncertainty around forecasts
Companies are currently trying to forecast the impact both directly and indirectly of the COVID-19 virus on their cash flows.
The extent of the changes in the business environment, that most companies operate in, has been extreme and the full impact of COVID-19 may still remain relatively uncertain. It is a very difficult time to forecast for companies as demand for products may have changed significantly and it may not be appropriate to use the current run rate.
Some key questions that companies should consider when producing cash flows estimates include:
- What are the direct and indirect impacts of COVID-19 on the business or assets under review?
- How can this be captured in the short, medium- and long-term forecasts?
- Is the model robust and flexible enough to perform a regular reforecasting exercise as new information becomes available?
Linked to the re-examination of projections and forecasts, companies should consider whether the impact of COVID-19 is an indicator of impairment.
If COVID-19 is an impairment trigger, under IFRS or UK and Ireland GAAP, a full impairment assessment would be required to be performed. It is highly likely that this is the case given the Irish government’s response to COVID-19 and its impact on many industries and sectors. A cessation of operations (even temporary), a significant adverse change in the economic or legal environment in which the investee operates (e.g. recession) or an immediate decline in demand, are all impairment triggers that would require an impairment assessment to be performed.
One clear impact of the current crisis is on a company’s potential impairment analysis. Companies should act sooner rather than later to assess the impact of a triggering event on their carrying values. Some questions to consider:
- What is the triggering event and on what date did this occur?
- What were the expectations at that time in terms of the period of the downturn and recovery?
The principles guiding the selection of a valuation approach remain unchanged. However, previous models may no longer provide a reliable valuation conclusion and care should be taken to ensure that the approaches appropriately account for current market data, or lack thereof. It is more important now than ever to consider multiple approaches (and considerations as set out below) to triangulate fair value.
- The impact on short and long-term cash flows needs to be estimated. It is important not to rely only on current run-rates. Special attention should be given to historical results, expectations of cash flow during the economic downturn and beyond and the expected timeline of the economic decline
- Some companies may experience a short-term boost to sales that may ultimately dry-up in the coming months. Other companies may need to consider potential supply chain disruptions
- Discount rates (as further explained below) may need to be reconsidered.
The income approach can be very sensitive to changes in the discount rate. The current market conditions as a result of COVID-19 have effected various elements of the discount rate which may result in a significantly different conclusion when arriving at a valuation conclusion. Such impacts include:
- Investors flight-to-quality meaning government bonds are arguably no longer reflective of risk-free rates. While these rates have fallen due to a flight-to-quality, this is offset by an increase in equity risk premium and credit spreads.
- The beta will have been effected by the recent volatility seen in the stock market. The impact on historical betas will depend on the period over which the beta has been calculated and the selection of market index.
- Credit spreads have increased in recent weeks, impacting the cost of debt for both Weighted Average Cost of Capital (WACC) calculations and incremental borrowing rates.
- Capital structure weightings of Debt-to-equity will shift based on decreases in equity market capitalisation for comparable companies. Where possible, the market value of debt should be considered to ensure that the ratio is not distorted. It is worth noting that debt-to-equity ratios remain impacted by IFRS 16 and those companies which have implemented versus those who have not.
Special care should be taken in order to match discount rates to risks inherent in any prospective information and performance risk should ideally be reflected in the cash flow forecast rather than adding an alpha (specific company risk premium) to the discount rate.
Our experienced team of valuation experts can assist you with dealing with these questions.