The Impact of COVID-19 on Business Valuation
- April 7, 2020
In these times of uncertainty as the COVID-19 pandemic continues to unfold across the United States, most healthcare entities are changing their focus from their previous recent efforts to join in the global fight. Many pending alignment transactions are stalled due to the attention to the urgent, and efforts toward new deals have canceled.
Time will tell the total impact the pandemic will have on transaction volume.
Once alignment discussions resume, valuation professionals will need to rely heavily on their training and professional judgment to assist clients in assessing value. A few key considerations surrounding these efforts are outlined below.
Cash Flow Projections
There is a fundamental understanding that valuation is forward-looking. As valuators, we use our training and experience to put forth cash flow projections that reflect what is “known or knowable” at the time of the valuation. The change that is occurring around the world is material and rapid. Therefore, the valuation of an entity as of December 31, 2019, will look dramatically different than the valuation of the same entity as of March 31, 2020.
Additionally, 2020 revenue and expenses will assuredly reflect significant fluctuations from historical trends and will not reflect a normalized level of operations for the basis of forecasting a subject entity’s cash flow. Therefore, valuators will have to be acutely aware of the need to make normalizing adjustments to both revenue and expenses as part of their forecast models.
Depending on the specific entity type, these adjustments will be more or less material. Furthermore, there is significant uncertainty surrounding how long the pandemic will continue, meaning the development of cash flow projections will require substantial judgment based on the facts known at the time of the valuation.
The increased uncertainty, and risk associated with the cash flow projections, will need to be accounted for within the selected discount rate used within the valuation.
The selection of a discount rate is meant to align the relative risk associated with an entity’s operations, or an investment in the subject entity, compared to alternative investment options and their associated rates of return.
In times of crisis, and with extraordinary market volatility, it becomes paramount for valuators to view market data through a different lens. For instance, similar to the 2008 recession, the 20-year treasury yield has fallen as investors jump into safer investments.
However, as the 20-year treasury yield represents the first building block of many valuators’ calculation of an entity’s return on equity, the decreased rate represents a data point that is directionally opposite of the increased risk inherent with making an investment in most business as of a current valuation date.
Valuators must take care not to operate mechanically but to be consciously aware of the data and assumptions relied-upon.
Principally, whether through a risk-free rate adjustment or within the valuators’ determination of the company-specific risk premium, the discount rate selected must match the inherent risk of achieving the cash flow projection of the subject entity. The discount rate must also be derived based on what is “known or knowable” as of the valuation date.
Discount for Lack of Marketability
According to Valuing a Business: The Analysis and Appraisal of Closely Held Companies, the typical definition of marketability is “the ability to quickly convert property to cash at minimal cost with a high degree of certainty of realizing the anticipated amount of proceeds.”
The International Glossary of Business Valuation Terms defines a discount for marketability (DLOM) as “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.”
As within the last several weeks, there has been a marked increase in both price volatility and uncertainty surrounding continued business operations, it would be expected that the DLOM applied would be increased, likely materially, to reflect these conditions.
Guideline Public Company and Comparable Transaction Multiples
Under the Market Approach, care must be taken, both now and in the future, when relying-upon reported and calculated multiples. A multiple reported even a month ago would materially misrepresent the risk associated with a comparable transaction today.
Further, as we move past the current pandemic, valuators will want to consider carefully the use of multiples associated with transactions that occurred both during and in the wake of this global crisis.
Business valuation professionals are trained to use their professional judgment, technical experience, and discipline to opine on complex arrangements. These pillars of valuation are more critical than ever as we continue into uncharted territory for the world economy.
The professionals at Coker Group are here to assist in these trying times. Contact us today to leverage our experience in the healthcare valuation field and get your operations forward-looking once the current crisis subsides.