One of the most common approaches to business or property valuation is the income approach, which often takes the form of a Discounted Cash Flow (DCF) valuation method. In the field of valuation, the income approach is a widely accepted method, and one of the primary approaches used in estimating a business enterprise value or asset values.
Even in normal times, small changes to one of the myriad assumptions or inputs laying the foundation of an income approach valuation model can have dramatic effects on its conclusions. The OECD Guidelines raise this topic in Paragraphs 6.157-6.158 by stating:
“Small changes in one or another of the assumptions underlying the valuation model, or in one or more of the valuation parameters, can lead to large differences in the […] value the model produces.” As such, “valuation requires, among other things, defining realistic and reliable financial projections, growth rates, discount rates...”
Today, the financial impact of COVID-19 must be considered in the valuation process. The following sections outline certain valuation assumptions, and, due to economic uncertainty and volatility, modifications that may be necessary in your approach.
Accounting For COVID-19: 4 Modifications To Consider
1. Discount Rates
Discount rates account for risk and the time value of money of expected cash flows. While the facts and circumstances of any analysis require consideration on a case-by-case basis when developing a discount rate, the Weighted Average Cost of Capital (WACC) is amongst the most used approaches. We can look at certain inputs to a WACC calculation and how they might need adjustments due to recent events.
Without adjustment or normalization, the inputs to a WACC could lead to a relatively low discount rate due to the uncharacteristically low price of government securities and volatile market conditions. A lower discount rate would lead to higher valuations, which would be counterintuitive and may not be reflective of higher risk levels for many businesses during the COVID-19 crisis.
Before adjusting the WACC, it is essential to understand the business-specific and industry impact of the crisis. Consider multiple aspects like customers, sales, employees, business continuity, and the supply chain. A minimally affected industry like healthcare REITs may be currently experiencing relatively minor disruptions in the short or medium term, and likely the discount rate has not changed much from what it was a few months ago. Yet, other industries are significantly impacted, such as the airline industry, which is facing issues including decreasing passengers, cancellation of trips, route limitations, and disruption of other services.
Once the state of the industry is understood, it is important to ensure that the assumptions used appropriately reflect exposure to this crisis. The less exposure to the crisis, the more appropriate it is to use longer-term averages and inputs that represent more normalized economic conditions.
The chart below outlines considerations for each component:
|
Component |
Description |
|---|---|
|
Debt/equity ratios |
Guideline companies in similar industries and observing their debt to equity ratios are a standard method to determine relevant market-driven inputs. Consider the industry and how companies are responding to the crisis. Are they taking on significantly more debt as a result of extended payment terms and operational needs? To the extent they have, consider using an average ratio over time, or an industry standard. |
|
Cost of debt |
Using corporate bond yields for a particular credit rating is an accepted method to measure the cost of debt. An average rate over a period of time may also be used. Consider whether the “standard” credit rating typically employed, such as BBB, is still applicable given today’s market. For example, look for rates on any debt issued by the company or comparables before the crisis. Alternatively, speak with the corporate finance team to see what data is available from banks, lines of credit, etc. |
|
Risk-free rate |
Due to the COVID-19 epidemic, using a U.S. treasury yield spot rate in the heart of the crisis may not be appropriate as it would be affected by quantitative easing measures and government balance sheet deviations. A normalized risk-free rate using a trailing average of historical rates (the length of time chosen may vary, but most academic literature suggests using a trailing period for a treasury bond with a 10 year maturity) is worth consideration. |
|
Beta |
It is common to look at a long-term average or median beta for a guideline set of companies, and then un-lever and re-lever the beta to account for the capital structure being used. As noted above, be sure to consider the debt/equity ratios in the calculation carefully. |
|
Market Risk Premium |
There are multiple options for the selection of market risk premium, offered by multiple sources such as Duff & Phelps and Damodaran. Consider whether the approach used adequately contemplates market conditions during a potential recession economy. Certain sources of this data have recently increased their suggested market risk premium – for example, in March, Duff & Phelps increase their recommended market risk premium from 5.0 percent to 6.0 percent. In general, choose the appropriate premium for the valuation based on the valuation date and qualitative assumptions. It is not recommended or common for taxpayers to derive their own market risk premia. |
|
Other Premiums |
Other risk premiums (e.g., country risk premium, size premium, and company-specific premium) can take many forms depending on the business model and operations. Consider whether any of these premiums require modifications based on the current crisis. For example, size premium studies are typically done once per year (before the crisis), so it may be appropriate to adjust the bands downwards by the market decline when choosing the size premium for the company. For country risk premiums, consider whether any adjustments are necessary based on how COVID-19 has impacted the given jurisdiction. Also consider whether additional risk is captured in the beta used and set of guideline companies chosen for other inputs before applying additional risk premia. |
2. Financial Forecasts
Forecast methodologies vary from business to business and usually include direct and indirect approaches (sometimes referred to as “top-down” and “bottom-up” approaches). For example, modeling sales forecasts can be done by entity or business unit level and then those forecasts are subsequently added together to form a consolidated forecast (i.e., bottom-up). Other items, such as operational expenses (e.g., overhead and administration services), might benefit multiple business units differently. These expenses should be appropriately allocated from a general business-wide forecast (i.e., top-down). Choose the forecast methods carefully and document them for future reference.
For valuation and transfer pricing purposes, both the OECD Guidelines and the U.S. Regulations indicate that projections prepared for non-tax business planning purposes are more reliable than projections prepared exclusively for tax or transfer pricing purposes. Therefore, consider working with the various departments in the business to compile or review non-tax projections for the company during the COVID-19 crisis. Be sure to align projections with the valuation date of the analysis and not include any items that predate the pandemic.
Paragraph 6.173 of the OECD Guidelines also warn that:
“Certain risks can be taken into account either in arriving at financial projections or in calculating the discount rate, care should be taken to avoid double discounting for risk.”
Avoid combining a normalized discount rate with normalized projections, thereby ignoring the consequences of the current market conditions entirely.
3. Growth Rates
Paragraph 6.169 of the OECD Guidelines states:
“It would generally be expected that a reliable application of a valuation technique based on projected future cash flows would examine the likely pattern of revenue and expense growth based on industry and company experience with similar products.”
While future market conditions cannot be known, valuation modeling post-COVID-19 should at least account for the possibility of a flat or recession economy. The extent to which growth is affected also depends on the products, industry, and what is being valued. Think about the goods or services within the context of elasticity of demand. When economic times are good, does the demand for the products or services go up or down? For additional guidance, look at the company’s historical performance during periods of economic uncertainty, if possible. Lastly, consider a longer forecast period extending through a potential economic recovery, after which point a “normal” terminal growth rate can be considered (if applicable).
4. Sensitivity Analysis
During this especially volatile time, be sure to stress test the valuation results under different scenarios (e.g., expected, worst-case, better-case). (Tweet this!) The use of relevant valuation methods should be carefully evaluated. Consider which inputs and assumptions can be flexed to approximate a reliable result (or an arm’s length range of results where applicable). Discount rates, growth rates, financial ratios, rate spreads, and probability weightings are several options. Whichever scenario is ultimately used, be sure to document the reasons and assumptions carefully.
Conclusion
In general, the issues outlined above should provide a reasonable starting point of topics to consider when performing a valuation during this crisis. Creativity and practicality are important components of valuations, particularly as the financial impact of COVID-19 continues to unfold.
Any opinions expressed in this article are those of the author, and not necessarily those of Valentiam Group.
Topics: Business valuation, COVID-19
