How the Value of Your Business Might be Impacted by Coronavirus
The equity markets are highly volatile. Economic indicators are plummeting as severely as in the financial crisis of 2008, if not more in some cases. The business climate is characterized as uncertain at best. The cause: a global healthcare crisis. Unprecedented times. And with the end of the Coronavirus pandemic nothing more than speculation, even by the smartest doctors on the planet, business owners need to know how this will impact the value of even a historically stable and well-capitalized company.
As much as we can turn to traditional economic models to explain cycles of boom and bust, this pandemic has created an entirely new paradigm that is uncharted territory for everyone. The crisis is uncommon and, by definition, that means the outcome is unpredictable. Given the fact that the materiality of economic impact on the global economy is just a guess for now, the best we can do is reflect on how business values are calculated and consider the various influencing forces that may affect them.
The International Glossary of Business Valuation Terms defines fair market value as “the price expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
It is important to appreciate that the value of a business is determined on a specific date or an effective date. Only information that was “known or knowable” on that given effective date should be reflected in the valuation. Therefore, the value can vary from one effective date to the next and that variation can be material.
Factors that affect the value determination of a business include but are not limited to:
- Nature and history of a business
- Economic conditions and outlook in general and industry conditions and outlook for the specific industry
- Net asset value and the financial condition of the business
- Earnings capacity
- Dividend paying capacity
- Existence or nonexistence of intangible assets and the value of them
- Prior sales of stock of the company and the size of the block to be valued
- Prices of stock in companies engaged in the same or similar line of business
Hypothetical buyers and sellers base their opinion of “price” (value) on what they believe will happen in the future in terms of potential returns that will be realized on investments (earnings). Risk assessment is considered an integral part of the equation in terms of perceived amounts, timing, and likelihood of receiving those returns (earnings).
As we consider the aforementioned factors in determining value, the current environment in the context of external risk elements can be categorized as follows:
- Economic conditions – Conflicting reports on whether a recession is officially underway and how deep it may go
- Industry conditions – Entire industries under orders to cease operating
- Government regulations – Increased intervention at federal, state and local levels
- Stock market returns – Volatility is the current expectation
- Tax rates – Political uncertainties compounded by questions around who will ultimately fund the stimulus
The traditional internal risk elements add more color in the current climate:
- Business operations and time in business – Shutdowns and shelter-in-place conflicts
- Earnings history (stable or volatile) – New business cycle histories are being written
- Earnings expectation (high or low growth, decline, flat) – Projections need to be reconsidered
- Balance sheet, financial strength (level of cash and debt) – Cash flow is being challenged while the need for cash is heightened
- Cash reserves – Profitability, working capital and decisions on capital expenditures being postponed or accelerated (potential for excess capacity in the future)
- Customer concentration – Highly concentrated customer portfolios face even greater uncertainty
- Sufficiency of supply – Disruptions in supply chains are abundant as facilities are or have been closed; some might now be opening but with a different production focus
- Management experience and depth – Experience addressing a pandemic is far from the norm
Approaches to Value in Context
The three approaches to value a business are the Market Approach, Income Approach, and Asset-Based (Cost) Approach. As the first two are more directly impacted by the pandemic, we’ll focus our attention on those two methodologies here.
The building blocks of the Market Approach include expected future returns (earnings, EBITDA, revenue, cash flow) and the market multiples to apply to those financial metrics. For many industries, multiples are currently low. Meanwhile, earnings are typically based on actual, recent earnings and the pricing ratios are typically based on current risk perceptions, which likely include an expectation that earnings will decline for many.
Thus, price is already reflecting assumed lower earnings, although actual/reported earnings haven’t been affected (or even announced) yet.
As time passes, actual earnings are likely to decline in many industries. The pricing ratios will change but initial “shock” to the price has already occurred, so change in future might not be as dramatic. As a result, multiples may be higher.
The basic building blocks of the Income Approach include forecasted returns (cash flow) and the discount rate.
The forecast reflects revenue growth or decline and timing of that; profitability of periods in the future; capital expenditure expectations; and government actions, such as tax rates or cash influx from bailout.
The equity discount rate derivation under the build-up method, which is used with the Income Approach, represents the layering of different risk elements (based on a risk-reward scenario); risk-free rate (based on U.S. Treasury Bonds); equity risk premium; adjustment for relative industry risk; adjustment for size (smaller generally more risky); and adjustment for elements specific to the subject company. The approach further considers the rate of return on debt (i.e. interest rates) and weighting of equity and debt in sources of capital.
Looking at these factors today, we’d have to question what a reasonable forecast could be considering the timing of revenue changes, effect on profit margins, and the one-time government influx of funds.
Furthermore, determining the appropriate equity discount rate is challenged with an assessment of perceived risks. The risk-free rate is subject to Federal Reserve actions that lower this rate, even though perceived risk is greater. Equity risk premium, industry risk, and size risk are all long-term measures. Companies, of course, are facing their own individual plethora of risks.
Meanwhile, the current shock to the market and increased perceived risk is not completely captured. How can it be? The cost of debt is completely unknown in these unprecedented times, although it will likely be lower for a while.
As the value of equity declines, debt will temporarily be a higher portion of the capital structure.
We also need to consider the relationship between forecast and discount rate. If the forecast is more conservative/pessimistic, then risk reflected in the discount rate can be less. If the forecast is more aggressive/optimistic, then risk reflected in the discount rate should be higher. However, different investors and analysts will have different perceptions of future expectations for cash flows and risk. Valuations should reflect the view of “hypothetical” owners.
The Current Reality of Multiples and Value
With the current level of uncertainty, there are lots of questions as to whether forward multiples are meaningless and which public companies have updated their forecasts with any degree of reliability. The equity markets are behaving with such short-term inefficiency that we also need to consider whether trailing multiples are reliable.
Even considering government stimulus, businesses are currently dealing with a liquidity crisis of unknown duration, forcing them to examine cost structure and make adjustments (e.g. stop rent payments, reduce workforce, extend payables, etc.).
Fundamentally, value is created through cash flow, growth and managing risk. Some sectors are faring better than others, but no company or sector is fully insulated from the pandemic’s impact. As demand shifts dramatically and consumers hunker down, providers are feeling the pressure. Simultaneously, production is also down and the workforce is in a state of flux.
As demonstrated by Dyson for one example, a company best known for vacuum cleaners, production opportunities exist for companies that can pivot. Dyson has started to manufacturer ventilators, but that’s only one of countless examples of companies that are seeing an opportunity and going for it.
The Impact on Litigation
We all know that litigation is expensive. That truism is accentuated by the fact the court systems need to work through the impacts of COVID-19 to find workable means to administer justice.
One probable outcome in the immediate future is that frivolous, riskier lawsuits are likely to diminish.
Business interruption is the word of the day as businesses are turning to the courts to confirm whether insurance should cover Coronavirus-related business losses. Insurers, unsurprisingly, believe most policies should not cover COVID-19. Meanwhile, the U.S. property and casualty industry surplus of approximately $1 trillion would be gutted if you consider continuity losses are estimated at somewhere between $200 and $400 billion per month.
A New Take on Intellectual Property
The traditional underlying economic premise is that innovators should be compensated for their research and development efforts through profit.
While that may be the case in normally functioning markets, our current circumstances dictate a focus on developing and deploying an effective vaccine or anti-viral to as many people as possible and as quickly as possible.
The biggest patent story of the year is patent filings around use of anti-viral drug Remdesivir, created by Gilead, to treat COVID-19. Meanwhile, the World Health Organization is petitioning to create a voluntary pool funded by both the public and private sectors to collect patent rights, regulatory test data and other info that can be shared and used to develop a vaccine quicker.
The question is whether this will affect expectations on intellectual property beyond this situation.
The Time to Plan is Now
Businesses and their owners should seize the opportunity to start planning in the midst of this “new normal.”
For example, consider your current estate and your projections for the future as you reassess or dive into your estate and gift tax planning. What are your wealth transfer plans? Can you take advantage of a potentially lower valuation?
Getting through this time and coming out on the other side of it without losing your identity or market position—and perhaps capturing a new market position—requires the right people. Companies should be looking at their key employees and providing the right incentives to keep them engaged and adding value. Equity incentives can be an effective means of motivating your key people, especially at a lower equity valuation.
Valuations and Timing
If a valuation has a rolling date (i.e. for a litigation matter) you should consider updating the valuation. If an individual passed away prior to the crisis and the valuation of their business has been significantly impacted, consider an alternative valuation date for estate tax compliance purposes. If you are considering an S corporation election from C corporation status, consider a current valuation, as that may mitigate the amount of built-in gains. If an Employee Stock Ownership Plan (ESOP) has an annual valuation cutoff date of December 31, consider an interim valuation for purposes of distributions, based on share value that may be artificially high as of December 31, 2019.
Merger and Acquisition Opportunities
The level of disruption we’re seeing right now will lead to new opportunities for buyers and sellers. Many viable businesses will only come through this with new guidance and/or leadership. Others might emerge but owners might ultimately lack the drive to continue. Consolidation might be the best chance at survival. Expect M&A opportunities to emerge and do your best to position yourself for whichever side of the equation suits your goals for the future.
Cash Flow Considerations
Between the CARES Act and SBA loans, as well as business interruption insurance and expense management, businesses need to address every avenue to manage cash flow while protecting their value.
In spite of the economic uncertainty around timing as well as individual health considerations and market fluctuations, we know we will emerge from the current crisis. When we do, we’ll need to consider whether this was a non-recurring event or, alternatively, how long a business may be impacted.
Furthermore, every business will have to assess the long-term effect on its competitive landscape. Will your environment be changed forever due to business failures? Will new sources of direct and indirect competition emerge? The financial crisis associated with the Great Recession led to the birth of a gig economy, among others developments. Today, gig workers are facing new challenges and questions around the stimulus.
Time will tell what the one-time stimulus will mean for those individuals as well as for established businesses and the economy as a whole.
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