World markets, central banks, governments and citizens in almost every economy across the globe are grappling with the financial fall-out of the global COVID-19 pandemic. The loss of investor confidence and significant uncertainty as to the future has seen major sell-offs, lower valuations and unprecedented economic interventions. COVID-19 has made the prospect of a global recession very real.
In this fraught economic climate, Fund Managers and other investors need to consider carefully their investment valuations in the coming weeks and months.
The current economic climate will also provide “value” opportunities for brave investors who are willing to look beyond the current crisis and appreciate value fundamentals of target companies in a normally functioning economy.
We identify below key considerations when appraising value in the midst of the COVID-19 pandemic using the Market and Income Approaches.
Market Approach Considerations
Navigating the challenges presented by the current prevailing economic environment is critical when undertaking a meaningful Market Approach. Key valuation consideration for this approach include:
- Comparable company data and statistics: Given the prevailing economic climate establishing an appropriate comparable peer set may be challenging. The subject company may differ from the comparable companies in terms of both business offerings and financial stability. It is important to understand these differences and how these differences might impact on value.
- Current multiples: Market valuation multiples are typically calculated using the current market value compared to an historical or lagged financial metric (ie prior quarter EBITDA) which will not truly reflect the expected run-rate given the temporary or permanent disruptions in the business cycle.
- Forward-looking multiples: The principles of valuation together with empirical evidence indicates that multiples should be based on forecast profitability as opposed to historical performance where possible. Analysts have not yet revised forward earnings expectations based on the new economic reality and therefore forward valuation multiples may no longer be entirely meaningful.
It is important to understand how the subject company and each of the comparables may be impacted and valuation multiples should be considered on a case-by-case basis.
Income Approach Consideration
The Income Approach may be the most meaningful analysis in a valuation analysis. However, it is not without its challenges; particularly where significant economic and business disruption is occurring.
- Determining cash flows: Long-term cash flows should be estimated based on either expected cash flows or probability weighted cash flow taking into consideration what is known as at the valuation date. 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 increase in sales which may represent a term benefit as the economy changes gear and may ultimately decline in the coming months. Other subject companies may need to consider potential supply chain disruptions and corresponding impact on cash flows.
- Discount rate derivation and application: Discount rates are one of the key drivers of the Income Approach. Special care should be taken in properly matching 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. Although risk free rates have declined, this is offset by an increase in Equity Risk Premiums and other inputs like betas, interest rates and other risk measures.
Reconciliation Between Approaches
It is important to understand the key drivers in each valuation conclusion derived using the approached outlined above and not simply rely on mathematical formulas. Each valuation input should be evaluated to identify the cause of any differences. In certain instances it may be appropriate to reassess the market multiple that has been employed, consider differences in forward-looking multiples versus historical multiples and / or reflect on whether EBITDA is indicative of a true recurring level of performance. In an Income Approach a re-evaluation of growth rates, margins, terminal value calculations and discount rates will ensure you are properly aligned.
The Grant Thornton Valuation Team is actively exploring all these issues and are available to assist you during these uncertain times.