By Randall C. Raifsnider, ABV, ASA
From a business valuation standpoint, the COVID-19 pandemic has been a challenge for valuation professionals. Traditional valuation methodologies and approaches needed to be tailored to the unique circumstances of this global event. While there are no hard-and-fast rules or procedures that valuation professionals must employ to appropriately estimate value in the COVID-19 age, what I present in this blog must be considered to arrive at a realistic estimate of value.
Subject Company Risk Assessment
One of the first tasks in estimating the value of a business is executing a thorough risk assessment of the subject company. The widespread economic consequences of the pandemic have changed the risk profiles for many companies. Additionally, the operations of certain businesses, including retail and restaurant operations, have been severely hampered. At the same time, other businesses (including certain construction businesses, medical supply companies, etc.) have seen revenues and profits increase dramatically since the start of the crisis. As such, it is critical for valuation professionals to provide a detailed risk profile of a business as of the date of valuation. Factors normally considered as part of a subject company risk assessment include personnel changes, limitations on management depth, changes in the subject company’s customer and/or supplier base, sensitivity to raw material price changes, among others.
The aforementioned risk profile developed for the subject company will be incorporated into the estimation of the capitalization rate (or discount rate if projected financial information is used) if an income approach analysis is performed. The capitalization rate is an estimation of the rate of return that a hypothetical investor would require if they were to invest in the subject company. This rate is a key driver in the development of value of a company. Many of the inputs used in developing the capitalization rate are published data based on historical economic performance (typically based on U.S. Treasury security yields and equity market performance), but a premium based on the specific risks of the subject company is also included as part of the estimation of the capitalization rate. Due to the pandemic-induced economic downturn, many of the economic inputs used to calculate the capitalization rate have changed. Thus, a premium for the specific risks of the subject company must be estimated thoroughly to ensure that a realistic capitalization rate is used to estimate value.
When reviewing the historical or projected financial information of a subject company, the valuation professional will consider the need for adjustments to income or expense items that may be nonoperating or nonrecurring in nature. These are referred to as normalization adjustments. The adverse economic impacts of the pandemic have resulted in companies realizing income that may be nonrecurring in nature along with many one-time expenses. These must be analyzed meticulously, and those items that are deemed to be nonrecurring or nonoperating must be eliminated from the valuation analysis to provide an estimate of the subject company’s future earnings capacity based on economic reality.
Weighting of Periods
Valuation professionals using either the historical or projected future income streams of the subject company must consider the need for weighting the financial results of 2020. Valuators often average the results of three or five years’ worth of historical financial information to obtain an estimate of the future earnings capacity of a company through a full business cycle. The financial results of the periods affected by the pandemic may be an anomaly for the subject company when compared with prior or future periods. As such, a weighted average of the historical or future financial results, weighting less for periods impacted by the pandemic, may be necessary.
When using financial projections for a discounted cash flow analysis, use care in reviewing the projections and communicating with management to ensure the assumptions used reflect the anticipated results of the subject company in the current economic climate. Items such as decreased revenue due to customer attrition, increased raw materials costs in cost of goods sold, and fluctuations in operating expenses must be carefully reviewed prior to using financial projections in a valuation analysis.
Given the changes in the economy, valuation specialists should be wary of using transaction multiples from 2020 through the guideline company transactions method. If this valuation methodology is employed, a detailed review of the specific factors making up the transaction multiple must be performed, specifically the inclusion and amount of any earn-out payments.
Randall C. Raifsnider, ABV, ASA, is partner, management advisory services, for Herbein + Company Inc. in Reading. He can be reached at firstname.lastname@example.org.
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