COVID-19: Valuation Techniques

This is the fifth blog in Davis Martindale’s Valuations and “Covid-19 Mini Series”.  

In our previous Covid-19 blogs, we discussed:

1. the timeline of the build up to the current social distancing measures;
2. use of hindsight in valuation – whether knowledge of the economic impact of Covid-19 can be incorporated into a value determination;
3. potential Covid-19 disclosures, and reporting options that you may see in valuation reports; and
4. impact of forecasting the recovery on valuations.

In this blog, we discuss potential valuation techniques and the importance of forecasts in the context of Covid-19.

While there is a subjective component to valuation analysis, much of the work is based on collecting financial data, understanding the subject company, the industry, and the economic environment. Chartered Business Valuators often need to make reasonable assumptions when preparing valuations, especially in the face of uncertainty. Now, more than ever, valuation professionals need to rely heavily on their training, and professional judgement to assist clients in assessing value.

The Capitalized Cash Flow Approach

In the most basic sense, the value of a business is equal to the present value of its expected future cash flows. When detailed and reliable forecast Income Statements are not available, a common valuation technique to use is a capitalized cash flow (“CCF”) approach. The CCF approach assumes that recent historic cash flows approximate those expected in the near future (adjusted to remove non-recurring transactions that may have occurred in the past). This valuation approach can be appropriate when valuing a mature, stable business that does not expect much change in the future.

With the economic uncertainties surrounding Covid-19, it may no longer be reasonable for some companies to assume that historical cash flows are indicative of future cash flows, particularly in the short to medium term. If this is no longer a reasonable assumption, what other valuation approaches are available?

The Discounted Cash Flow Approach

As historic cash flows may not be indicative of future cash flows, Chartered Business Valuators can instead turn to the discounted cash flow (“DCF”) approach. The DCF approach relies on projections that are prepared by the business. These projections can account for both recurring changes in cash flows as well as non-recurring events (such as Covid-19).

Preparation of reliable forecasts can be challenging, depending on the sophistication of a business’s management and accounting team. An added complication arises when major events (such as the Covid-19 pandemic) create a high degree of uncertainty about the future cash flows of a business. As a result, some potential variations of a DCF approach could include:

1. Preparation of multiple cash flow scenarios and relying on a weighted average. As described in a previous blog in the Covid-19 mini-series, Forecasting During Covid-19 without a Crystal Ball, there are multiple views for what shape the economic downturn, and subsequent recovery will take. Projections can be prepared based on multiple scenarios, with weighted results based on the expected likelihood of each scenario.
2. Determine the pre-Covid-19 value and adjust for the short-term expected cash flow changes. Each business is different – some will be impacted significantly by Covid-19 (negatively or positively), and others may not see much change. If a business is expecting short-term changes but then returning to normal in the future, it may be appropriate to determine the pre-Covid-19 value and adjust for the short-term expected cash flow changes.
3. Consideration of different short-term and mid-term risk rates. When preparing a valuation, Chartered Business Valuators look not only at cash flows, but also at the risks to achieve those cash flows. If the short-term and mid-term risks are thought to be different (for example, higher short-term risk, average mid-term risk), then it may be appropriate to consider multiple risk rates.
4. Adjust the overall risk rate. Rather than adjusting for the uncertain future cash flows, it may be appropriate to adjust the overall risk rate to achieve the cash flows, or the future expected growth rate.

While every valuation is unique, these are some potential approaches to deal with the uncertainty arising from Covid-19.

An Important Caveat – Double-Counting Risk

When incorporating the impacts of Covid-19 into a business valuation, it is important that the risks are not double-counted. As mentioned previously, business valuations fundamentally rely on two inputs – expected cash flows, and the expected risk to achieve those cash flows. If a business’s outlook is increasingly poor because of the Covid-19 pandemic, a valuation can consider this in two ways:

1. Include projections that have reduced cash flows; or
2. Increase the risk to achieve normal cash flows.

In theory, both approaches would result in the same business value. However, the business could be under-valued if the two approaches are combined incorrectly (i.e. cash flows are expected to decrease, and the risk to achieve the reduced cash flows is increased). Care needs to be taken that risks aren’t double-counted by incorrectly adjusting both cash flows, and risk rates.

If you would like a further discussion on any of the topics covered in our mini series, please do not hesitate to call our team.