The global pandemic, caused by Covid-19, has put the world in difficulties. From an economic perspective, the consequences of the current health situation are multiple: global equity market collapse (faster than the 2008 global financial crisis), volatilities spiking, supply chains disrupted because of lockdowns, production shutdowns, closed retail stores in many countries, job losses… all of this hurting consumer confidence. These times are challenging for valuation professionals, as they have to value assets with limited to no comparable evidence and while all the markets are facing an uncertain future.
When valuing a company in times of crisis, there is no reason to change the most commonly used valuation methods, being the Discounted Cash Flow (DCF) and market multiples methods. However, in this context, some valuation drivers may be impacted by the economic situation, and drafting financial forecasts becomes even more complex than usual.
When a market is disrupted at the valuation date by current or very recent events like the Covid-19 crisis, valuation professionals may face uncertainty in their valuation exercises, as the data and drivers available to them on this date are likely to relate to the market before the event’s occurrence. If professionals face a lack of relevant inputs, it compels them to extrapolate data from directly observable prices for similar assets or even count on unobservable inputs. Finding objective evidence to support the assumptions made can be difficult and lead to uncertainty.
The Covid-19 crisis, and consequently the uncertainty affecting the valuation process, raise numerous questions related to cash flows forecasts and drivers such as the discount rate and the market/transaction multiples.
Cash flows forecasts
Even though the pandemic of Covid-19 is a global event, not all countries and industries have been hit equally and hence may exhibit different recovery shapes (V-shaped, U-shaped, W-shaped or L-shaped). Economists consider that a U, L or W-shape is plausible for the US while China will likely follow a V-shape. In contrast, in Europe, no recovery is anticipated in 2021. Different factors will determine the intensity of the shock and the following recovery, notably the mutation of the virus, the possible second wave, the emergence of vaccines, the behavior of people as well as monetary, fiscal and health measures.
To make reasonable cash flows forecasts in these challenging times, one should first go back to essentials and start from revised macroeconomic and industry forecasts, with more thorough analysis than usual. Then the company prospects should be carefully assessed, and the existing business model may be reconsidered.
Valuation professionals should follow some best practices, such as stretching the forecast period or implementing a multi-scenario approach in order to cover the possible outcomes of the pandemic (pessimistic, normal and optimistic) and shapes of recovery. Moreover, one should pay attention to key cash flow items such as capex that could have changed with the evolution of the industry or working capital requirements that should be reconsidered (customers may not pay on time to conserve cash). In any case, focus should be put more than ever on the cash needed to overcome the crisis.
With a decline of sovereign yields (risk-free rates), downfall of stock prices (leading to an increased implied ERP), widened corporate credit spreads (affecting the cost of debt) and government stimulus packages supporting borrowings (leading to higher leverage ratios), discount rates should be revised. The main drivers used for determining the discount rate are the following:
- Risk-free rate: the 2008 financial crisis highlighted the limits of using, as the risk-free rate, the spot yield-to-maturity on a safe government security, without taking any further adjustments. During periods of “quality above all” and central bank monetary interventions, risk-free rate may appear to be abnormally low. Therefore, valuation professionals may need to normalize the risk-free rate with two different methods: (i) simple averaging (calculating averages of yields to maturity on long-term government securities over various periods) and (ii) various “build-up” methods (addition of different components of the risk-free rate). Today, the risk-free rate is around 0% in Europe and 3% in the US.
- Beta: the beta is usually calculated over a period of 3 to 5 years, therefore no change is required; it will take some times to see whether some industries will be affected in terms of correlation with market indices.
- Implied ERP (IRR resulting from current index level and its return forecasts): we currently notice a general trend for an increase in the implied ERP. Duff & Phelps has adjusted its recommendation of ERP from 5% to 6% for the US, and Damodaran’s implied ERP jumped from 5,8% in March to 6,5% in April. It has to be noted that the earnings estimates will be updated in the coming weeks/months, and therefore will probably lead to new ERP adjustments.
- Company specific risk premium: as its name suggests, the company specific risk premium is a premium conducive to each company. An increase in company specific risk premium may make sense if the valued company is/will be more affected than its competitors, due to specific circumstances. Valuation professionals should nevertheless be careful of not double-counting the effects of the crisis, via both the cash flows forecasts and the company specific risk premium.
- Leverage ratios: companies will probably borrow more with the government’s stimulus packages, lifting up leverage ratios. This would lead valuation professionals to carefully (re)consider the long-term financing needs of companies, especially if the companies’ business models are expected to be modified.
Market and transactions multiples
Market multiples declined significantly due to the current crisis and the collapse of the equity market. It is important to notice that the different industries are not affected to the same extent by the crisis: according to FactSet and Refinitiv, in the US and in Europe, the energy sector is the most affected (double effect of Covid-19 and oil prices collapse) while the IT and utilities industries the least.
Next to the drop of market multiples, transaction multiples are also expected to decrease because of the decline in M&A activity. Caution is advised when using these downgraded multiples together with company’s results under pressure.
More specifically within the framework of impairment exercises, the current crisis will most likely lead to cases where ‘Value in Use’ will be higher than ‘Fair Value Less Costs to Sell’ if the latter is calculated using the market multiples method, since these drivers declined significantly.
In these difficult times, besides the attention points related to cash flows forecasts and valuation drivers, it is even more recommended to use several valuation methods, in order to smooth the imperfections of each one, and conduct sensitivity analyses on the key value drivers. Valuation is not an exact science and requires more than ever professional skepticism.