What business valuation professionals need to consider when valuing your business.
With the COVID-19 pandemic, the world has changed dramatically, and every business has been impacted in one way or another. At all times, the economic environment in which a business functions influences management’s decisions about the operation and direction of a company. Investors consider the economic environment as they judge the relative risks and rewards of a particular investment versus alternative investment opportunities. In many industries, conditions at the national level will influence regional and local economies to some degree.
The COVID-19 effect has varying degrees of impact on businesses and their value. Since businesses do not operate in a vacuum, the economic downside will impact businesses and their operations differently. Businesses in certain industries have flourished in light of the pandemic, while others have shut their doors indefinitely or permanently.
Because of these extraordinary circumstances, business valuation professionals need to consider other factors in the valuation process and critically evaluate how to incorporate these comprehensive issues in the process.
Cash Flow Uncertainties
The uncertainty of cash flows needs to be assessed and its long-term financial implication incorporated on the business and its cash flow. With the economic uncertainty, the projections are more speculative. The appraiser will determine their level of comfort with the projections and what extra steps need to be taken to check the validity of the projections. The appraiser will determine if incorporating probability model addressing multiple cash flow scenarios make sense for the business to reflect the high degree of uncertainty. A higher risk negatively impacts the cash flows and the value of a business. All of these considerations will depend on a case-by-case basis and on the specific facts at hand.
COVID-19 didn’t impact the globe all at once, so timelines will vary from one business valuation professional to another. Some companies that conducted business with or in China may have been impacted earlier than others. The concept of known and knowable will need to be evaluated. The valuation professional needs to have a good understanding of the COVID-19 timelines and should decide when the pandemic was known and knowable as part of their considerations. Valuation as of year-end 2019 will not take the COVID-19 impact into perspective.
On the other hand, a valuation happening around beginning of March may consider some of the factors mentioned in this article to incorporate the uncertainty for a specific business.
Another factor to consider is if historical trends will be a good indicator of future performance and cash flow. With these extraordinary times, certain methodologies that rely heavily on the historical trends may not be the most appropriate. As of December 31, 2019, as noted earlier, a valuation professional will not incorporate any pandemic impact because it was not known or knowable as of that date. But in certain circumstances, it depends. If a business relies heavily on Chinese operations or customers and it has been impacted because of their economy shutdown near end of 2019 or early January 2020, then it would be taken into consideration.
Market volatility is an expression of risk and economic uncertainty. Because the markets have shown a high degree of irregularities during the pandemic, one should determine if these multiples are comparable or not. As noted, some industries have not been harmed or have had increased business while others have suffered tremendous losses and declines in profitability and earnings. The appraiser will determine their level of comfort with these multiples given the level of market volatility.
In order to help businesses during COVID-19, many received some type of stimulus package or other financial aid. The impact of the stimulus needs to be considered, as well as if the loan is forgiven or not. For instance, if all the PPP loan is forgiven, then it will only affect the expenses written off against the PPP loan. If not, then the unforgiven amount will have to be booked to the income statement as an extraordinary (non-operating) income and should not be considered in that year’s cash flow analysis. The appraiser will need to determine the impact on both the balance sheet and income statement in the valuation process.
New – and Unforeseen – Business Expenses
Both essential and non-essential businesses had to adapt to the pandemic, and they likely incurred additional expenses to accommodate their workforce and their customers. Business valuation professionals need to consider if the organization incurred any of these additional expenses like sanitizing, gloves, masks, etc. that they would not have needed prior to the pandemic. Also determine if these expenses are expected to continue in the future when analyzing the future cash flows.
The company-specific risk needs to be carefully considered to prevent any double-dipping of factors reflected elsewhere in the process. The valuator analyst will identify the relevant elements within the company-specific risk premium and their impact on the future cash flows.
Where Do We Go from Here?
To say 2020 is a unique year would be an understatement. However, our country – and our world – has dealt with pandemics, economic uncertainty, natural disasters, etc. In addition to 2020 having the extraordinary pandemic impact, it is also an election year that carries additional uncertainty in terms of wealth transfer and asset protection. While we can anticipate how to address some of these variables, the future is unpredictable. This is why is it more important than ever to conduct business transition planning for business continuity.