Covid-19: Fair Valuation Considerations for M&A and Private Equity amidst Uncertainties

The COVID-19 pandemic has led to a dramatic loss of human life worldwide and presents an unprecedented challenge to public health, public governance, food systems and the world of work. The economic and social disruption caused by the pandemic is devastating. Quite evidently, it has had a fair share of its impact on valuation practices and how we reach Fair values amidst the ongoing uncertainties.

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements should reflect market participant views and market data at the measurement date under current market conditions & sentiments. Estimating fair value generally involves judgment. The current uncertain environment requires extensive consideration of various facts and circumstances particularly in the rapidly changing macro-economic factors/environment.

Discounted Cash Flow: During the ongoing pandemic, many valuation professionals are using DCF models, rather than the capitalization of earnings method, to better capture temporary changes in the marketplace. The appropriate time frame for a DCF analysis depends on how long the subject company expects its operations to be disrupted. Some currently use two or three-year DCF models; others prefer to use a longer time frame. Here are a few key considerations for using the DCF method for valuing companies, post Covid-19:

1. Stress testing projected cash flows- Financial stress testing, or scenario-based forecasting, is a corporate planning tool that helps executives manage under pervasive uncertainty, such as the crisis we are facing today. This method starts by first identifying relevant macroeconomic and microeconomic risks and then correlating major factors that affect a company’s balance sheet and income statement with external drivers. The first step in any of this is coming up with the various risks that the company faces. Second step is correlate those major drivers that impact your balance sheet and income statement with external drivers. The key is to understand each individual step separately. Like during lockdown due to COVID-19, it is not just demand that got impacted but also the supply chain got disrupted. So even if demand would have been there, businesses would have found it difficult to fulfil it because of supply-side issues. So key elements of it, again, are to think about what drives your business and then, based on that, see what the various ways are to stress test one’s business and consequently, the cash flows using those specific drivers.
2. Adjustments with respect to Cost of Capital- While the facts and circumstances of any analysis require consideration on a case-by-case basis when developing a discount rate, the Weighted Average Cost of Capital (WACC) is amongst the most used approaches. WACC is calculated by applying specific weights to the costs of both equity and debt, according to the composition of the capital structure of the concerned firm. The pandemic and the associated challenges have compelled firms to hold greater amounts of capital to absorb losses. This has led to variations in the capital structure, which changes the computation of WACC. This has been one of the major changes. Without adjustment or normalization for Covid-19, the inputs to a WACC could lead to a relatively low discount rate due to the uncharacteristically low price of government securities and volatile market conditions. A lower discount rate would lead to higher valuations, which would be counterintuitive and may not be reflective of higher risk levels for many businesses during the COVID-19 crisis.
3. Adjustments to multiples for terminal values: A significant component of company’s value in a DCF model is provided by the terminal value of the company, which is often calculated based on either a multiple of revenue or earnings before interest, taxes, depreciation and amortization (EBITDA) or a perpetual growth rate to the last projected year. In view of the impact of COVID-19, an analyst may want to consider whether an adjustment to the multiples is needed in view of the changes in the market multiples of comparable public companies (which have generally declined). It may be argued that the multiples used in the calculation of terminal value should not be adjusted as the effects of COVID-19 are short-term in nature. However, one must really analyse if the disruptions caused to their businesses and industries are really short-term in nature or there is a permanent shift or change. Certain industries like cyber-security and co-working spaces have seen Covid-19 change their operations and performance drastically, thereby requiring revision in multiples for calculation of terminal values. The same goes for businesses such as retail outlets & leasing businesses, who have lost significant market share. While losing business during lockdown is temporary, the loss of customers in these sectors is fairly permanent, with customers finding convenience and cost-cutting alternatives through competitors. These revisions must adequately represent the changes involved. For firms having short-term implications, not applying changes to multiples may require them to extend projection periods.
4. Evaluating the projection period: In some cases, management may want to extend the projection period (for instance, from 2020-2026 instead of 2020-2025) and apply the multiples from prior periods or a terminal growth rate to a higher level of revenue or EBITDA after one extra year of growth in the terminal value calculation. A forecast extension or a multiple adjustment that affects the overall terminal value of the company should be closely reviewed by the analyst and may require a compensating discount rate adjustment to reflect higher forecast risk.

Considering all of the above, it must be observed that the situation relating to Covid-19 is fast changing, with changes in the global and regional landscape appearing on a regular basis. Performing a valuation in these market conditions should be more hands-on and accurately reflect the ground realities and major shifts in businesses