Are business valuations less reliable than they were before the COVID-19 pandemic?

As it spread rapidly around the world, COVID-19 caused great uncertainty alongside the imposition of significant restrictions surrounding travel and public gatherings. Market volatility and large declines in valuations of businesses resulted in Australia and globally, partly because expected earnings for many businesses were substantially lower than before the on-set of COVID-19 and its disruptions.  

Although many complicated and unprecedented challenges surfaced, the primary impact on business valuations amidst the COVID-19 pandemic was the increased market volatility that arose. Thus, discount rates were most likely to increase alongside debt margins and betas as investors became more risk averse. Additionally, ambiguity surrounding the true economic impact of COVID-19 combined with a lack of reliable economic forecasts caused uncertainty of business specific cash flows, which caused business planning and forecasting to become increasingly difficult and complex. Amidst these challenges, many companies also reported a rise in liquidity risk from being unable to deliver on short-term obligations. As such, rises in debt covenant breaches, insolvencies and asset impairments in the short to medium term were certainly expected.

Given this expectation, a key consideration for businesses within such industries is how they should best be valued. In addressing this matter, Walker Wayland Corporate Advisory Team attended the 2020 CA ANZ Business Valuation Conference held recently. 

Here are some interesting points from the 2020 CA ANZ Business Valuation Conference: 

CA Business Valuation Specialist Simon Dalgarno discussed approaches for businesses and valuers to take in adapting to COVID-19. He had a particular preference for the use of the Discounted Cash Flow (DCF) method for valuations, and demonstrated how to convert a valuation using the commonly adopted Capitalisation of Future Maintainable Earnings (CFME) method to achieve this.

Future Maintainable Earnings is the level of earnings which the business could expect to maintain in real terms regardless of short-term economic fluctuations. It is closer in concept to next year’s budget, and therefore the model is only valid when future growth and working capital are expected to be stable, and capital expenditure (CAPEX) is expected to depreciate on an ongoing basis. Given the economic impact of COVID-19, the CFME method would likely produce inaccurate outcomes due to future unstable operations in many industries.

Consequently, a Discounted Cash Flow (DCF) valuation can provide significantly more information about the value effects than a CFME. Primarily, it allows entities to capture the impact of the current situation and fully consider the future cash flow profile as the wider economy returns to a steady state. Given how past results will now be inaccurate predictors of future outcomes, recognising the rapid and substantial changes that took place in the economy will be critical. 

Whilst this recommendation is important for assisting valuers, an effective and adequate way of considering risks in business estimates and forecasts of recovery must be kept in mind, given the unprecedented and unpredictable nature of COVID-19. Specifically, valuations will vary significantly based on different assumptions about the return to normality and risk. It is also necessary to consider multiple cashflow scenarios based on the shape of expected recovery and ‘business-specific risks’ in order to produce a reasonable forecast. The use of broad assumptions regarding the impact and risks associated with COVID-19 on a business should be avoided, as it turned out to both positively and negatively impact the prospects of different business and industries. 

Using a line from the Conference to answer the question - it is easy to say ‘yes’ because of today’s uncertain times, but the better answer would be “the projections are more difficult to do now, but they are just as reliable as before.”