The Covid-19 pandemic has had a substantial impact on virtually all companies, and in so many divergent ways, that at this early stage there is no, or very little, visibility as to what the new normal is. Furthermore, the economic recovery profile will very likely differ by country and by industry sector. The recovery profile can possibly take the form of a “V” (a sharp decrease and recovery), a “W” (waves of ups and downs), a “U” (a more gradual recovery) or a “L” (a permanent rebasing). Although the equity capital markets reflect that the share prices in certain sectors have decreased substantially (cruise liners, movie theatres), whereas others have benefitted (e-commerce, video conferencing), the jury is still out as to the shape of the recovery, if any, for certain sectors. What all of this translates into is uncertainty in the market, and traditionally, uncertainty has a negative impact on the valuations of companies.
When valuing companies in these times of Covid-19, valuation practitioners need to consider the impact of the pandemic on a number of the elements of traditional company valuation methodologies. Typically companies are valued using the Income Approach (based on the value of the cash flows that the business can be expected to generate in the future) or the Market Approach (based on a comparison of the company to comparable publicly traded companies in its industry). The Income Approach or the Market Approach could be the primary valuation approach which would be benchmarked against the other approach as well as the Net Asset Value (NAV) of the company (NAV Approach).
The Income approach
The Income Approach will be influenced in a number of ways by the pandemic. Cash flows could be very different for the last twelve months before Covid-19, the period during Covid-19 and the short-, medium-, and long-term periods after Covid-19. The impact of second and even third waves needs to be considered. The first wave may have been cushioned by various government support initiatives but whether these will also be available for future waves, is questionable. All this means that forecasts and projections will need to assess the drivers of growth and one would need to critically and carefully consider market conditions, trends, and the impact of any government support programmes. In this time of uncertainty, scenario and sensitivity analyses will need to be utilised more extensively.
Normalised working capital levels may be difficult to ascertain and capital expenditure programmes may have been deferred. Careful consideration of these two elements are required in assessing the impact on the company’s future cash flows.
Besides the increased risk associated with the prediction of cash flows, other elements of the Income Approach are impacted and need consideration. There has been a marked impact on the potential discount rate to be applied to the cash flows, whether one uses the weighted average cost of capital (WACC), or the cost of equity, as a discount rate.
Government bond yields, which serve as the risk-free rate component of the cost of equity, are noticeably more volatile. Government bond yields in the US have come down substantially since the onset of the pandemic, which is likely as a result of the safe haven status of US treasuries. However in South Africa, yields have increased, which is potentially as a result of less demand for South African bonds, as well as the downgrading of South African bonds of late. One therefore needs to pay careful attention to the risk-free rate used in calculating the cost of equity. The unsystematic risk premium element of the cost of equity calculation would also need to be amended in instances where the beta used in the valuation does not adequately address or take into consideration the additional risk caused by the onset of Covid-19. Furthermore, the Covid-19 period may have resulted in more borrowings (higher gearing), coupled with changes in interest rates on the back of government interventions. This needs to be considered when calculating the WACC to be used in discounting cash flows.
The Market approach
The impact of Covid-19 on the Market Approach is also profound. Determining maintainable earnings will not be simple given possible fluctuations in company results before, during and possibly after Covid-19. Furthermore, comparable company valuation multiples, such as EV/EBITDA, and P/E multiples have potentially changed substantially. The share prices in certain industry sectors (such as the property and hospitality industries) have been decimated while others (such as IT) reflect increased valuations.
The NAV approach
The NAV Approach may intuitively seem to be the least affected valuation method. However, assessing the impact of Covid-19 on asset values may be equally difficult. Questions will need to be asked about the recoverability of debtors and the valuations of investments, properties and other assets of companies. Buyers will pay a lot more attention to the warranties in respect of asset values. In some situations, companies may no longer even be going concerns and liquidation values may be more appropriate in valuing these companies.
In summary, a lot more consideration will need to be applied to valuations at this time. Forecasting cash flows is even more complex. Valuers will need to perform significantly more scenario and sensitivity analyses and buyers will need to use mechanisms like earn-outs to reduce the risks around the volatility of earnings and cash flows.
Robbie Gonsalves, managing director and Sholto Piek, principal, Mergence Corporate Solutions.