DealMakers - 2020 Annual
Adjusting for COVID-19 in business enterprise valuations
by Neil du Toit
South Africa, and the rest of the world, has experienced significant global, social and economic disruption, including the largest global recession since the Great Depression, as a result of the COVID-19 pandemic. It has led to the postponement or cancellation of events, widespread supply shortages exacerbated by panic buying and other supply chain disruptions, consumer uncertainty, agricultural disruption and food shortages, as well as the partial and full closure of educational institutions.
Neil du Toit
During March 2020, the global stock markets fell significantly as a result of the pandemic, with the Dow Jones index falling from a closing peak of 27,091 on the 4th of March 2020 to 18,591 on the 23rd of March 2020 (with the largest one-day drop experienced in this month since the 2008 financial crisis). The JSE all-share index fell 28% from a peak of 3,795 on the 4th of March 2020 to 2,728 on the 23rd of March 2020 – its worst performing period since 1997.
The outbreak has been a major destabilising threat to the global economy, which has translated into market and share price volatility, as well as asset devaluations. While the markets have recovered somewhat since the significant losses suffered nearing the end of quarter one of 2020, the risk of a global second wave, as well as the logistical challenges of the vaccine rollout, indicate that the volatility will remain in the short to medium term.
In particular, the pandemic has created significant challenges in terms of valuing and pricing business enterprises and assets. By definition, valuations are prepared according to market value. The generally accepted definition of “Market Value” is the value as applied between a hypothetical willing vendor and a hypothetical willing, prudent buyer in an open market, and with access to all relevant information. For the purpose of this article, we will focus on the valuation of business enterprises.
The valuation of any business depends on its future income potential. Because the future is uncertain, the value of an asset or business is the current certainty-equivalent of its future uncertain benefits. In order to ascertain the value of the companies, the value of future benefits that will flow to the business needs to be determined. The value of the expected future benefits can be obtained through the application of various valuation methodologies. A valuation methodology is selected depending on the circumstances surrounding the asset to be valued.
One of the challenges in performing valuations is determining realistic expected earnings, and there is a risk that the forecast earnings will not approx-imate the eventual realised earnings; in particular, that the pandemic could have a higher than anticipated impact on the earnings, or that the anticipated impact on earnings could be overstated (for instance, certain industries have actually benefited from the impact of the pandemic). Furthermore, the timing of the recovery in earnings is uncertain.
There are several methods for allowing for the impact of COVID-19 in performing a valuation, being:
• The review of the underlying forecast earnings or “free cash flows”. This would entail performing a specific review of the quality and achievability of the projected financial results. As a result of the volatility, a valuer would be required to test the accuracy of the projections in significant detail, as opposed to a high-level, top-down approach and, accordingly, a linear forecast approach would not be appropriate. The projections would be required to be specifically interrogated with two key points required: What are the expected impact assumptions around COVID-19, and how have these assumptions been incorporated into the projections? In analysing these impacts, one could consider the quantum of the impact, the duration of the impact and the frequency of the impact (second wave of COVID-19).
• The adjustment to the discount rate and adjustment to the systematic and unsystematic risk premia. This would involve an adjustment to the market risk premium used, as well as an adjustment to the enterprise-specific risk premium. In preparing the market risk premium adjustment, the valuer can draw from wider macro-market data. In preparing the specific risk premium, however, the valuer would be required to conduct a specific analysis (or “mini-due diligence”) in order to ascertain the veracity of the future earnings forecasts which, as previously mentioned, will ultimately drive the quantum of the adjustment. Such factors could include, inter alia, robustness of the forecast preparation process, sensitivity to market factors (i.e. essential vs. non-essential market exposure), difficulty in producing accurate forecasts, cost rationalisation processes to minimise top-line impact etc. The premium adjustment would be based on personal judgment and should be used to supplement (not substitute) a thorough forecast review.
• The liquidity and marketability discounts will require review. These discounts are typically applied for unlisted or thinly-traded equities, in order to cater for the fact that an investment may take a period of time to be sold or require a discount adjustment in order to attract a willing buyer. It is likely that, in times of volatility, a willing buyer would not be desirous of paying the full transaction value of the asset, or that the asset would take longer to be disposed of.
In concluding, a valuation is not an exact science and is underpinned by a large amount of subjectivity. Along with the economic hardship and uncertainty that the pandemic has brought to many, it has brought significant complexity when determining the value of underlying assets and, accordingly, valuers are required to take care in ensuring that specific challenges are addressed.
Du Toit is an Associate Director, Corporate Finance, BDO South Africa.