The devastating health, social and economic impacts of the COVID-19 pandemic continue to dominate our lives. Even a casual observer of the stock markets has witnessed the extreme volatility and generally lower public company valuations since February’s peak. While share prices for private companies are not subject to daily judgment by investors, private company values will generally follow the recent public company trend: lower.
COVID-19 has impacted businesses and industries in different ways, much as the virus infects people in different ways. Not all businesses are worth less today; some are worth more than they were in 2019. Some businesses have seen little change and are operating at a “business as usual” level. Others have closed temporarily, some permanently. Others are realizing opportunities to innovate and grow, and will have higher future valuations.
In business valuation, a “one-size-fits-all” approach doesn’t work. The facts and circumstances specific to a company matter. I’ve outlined the key factors impacting company valuations below, as well as valuation considerations during this extraordinary time.
Valuation Date (a.k.a. “as of” date)
A business valuation is performed as of a selected date, referred to as the “valuation date.” A business valuer considers what was known and knowable at that valuation date, but should not factor subsequent events into the analysis. The valuation of a company as of May 1, 2020 could be very different from a valuation of the same company as of December 31, 2019.
Fast-forward to December 31, 2020 and that company valuation could be very different again. With newly identified medical treatments in place for COVID-19 patients, a vaccine potentially in advanced clinical trials and a reopened economy, we could be in an economic recovery. The timeline for a return to normalcy is impossible to predict. However, when it happens, we will see an uptick in economic activity as people get on with their lives and livelihoods.
Business valuations are forward-looking from the valuation date. Cash flow projections are a primary input to a business valuation. In a typical valuation analysis, we use either multi-year financial projections or a “realistic case” normalized year income statement. Many companies’ 2020 revenue and expense levels will be materially different from prior years’ results. Given significant uncertainty about the duration of the pandemic, impacts to a business in 2021 and beyond may need to be estimated.
In some instances, it will be difficult to develop a single set of financial projections due to company and industry-specific uncertainties. In those situations, valuation scenarios based on more than one set of financial projections (such as an optimistic case, base case and downside case) may need to be constructed and probability-weighted. The development of financial projections, as always, will require significant judgment and should reflect the facts and circumstances at the valuation date.
In private company valuations, we typically develop a value by discounting the projected future cash flows to present value at a selected rate of return (a.k.a. the discount rate). The discount rate reflects the risks of a specific investment – in this case the subject company. Changes in the discount rate directly impact company value. An increase in perceived company risk will result in a higher discount rate and will yield a lower company value, assuming no changes to other valuation inputs.
In volatile times, even the best thought-out financial projections might not be achieved. Only time will tell. To reflect this uncertainty in a company’s value, a higher discount rate may be appropriate.
Timing is everything: put plainly, the valuation date matters. This has different implications for different valuation purposes. The current environment creates a significant opportunity for estate planning and gift transactions at lower company valuations. For exit planning valuations with a near-term sale in mind, a scenario analysis using multiple sets of financial projections could be an informative exercise. For an exit planning valuation today with a year or longer to a potential sale, we have the luxury of time to take a view about the post-COVID-19 world.
Financial projections matter: until the business environment stabilizes, revenue and expenses may need to be projected by month or quarter (rather than by year) to best reflect a company’s outlook.
Higher risk = lower company values: until there is more clarity about the end of the pandemic, we will live in a high-risk business environment. Investors will demand higher returns, resulting in lower company values.
Stay well, stay busy and stay safe!