It would be ideal for the world to fast forward 6-9 months to provide more certainty for valuation opinions, that is not possible and some people are in the position of needing advice now.
The Courts are still open for business and continue to hear cases involving expert valuation opinions and mediations of matters are still progressing, be that for shareholder disputes, oppression matters, family law proceedings and estate disputes.
The challenge remains to provide an opinion or an approach that enables the Parties to make informed decisions. The vast majority of SME business valuations are prepared using the capitalisation of earnings approach, requiring an assessment of the future earnings of a business and application of an appropriate multiple. Historically even where there was a lack of forecast information, there was generally some information, whether that was historical trading performance and/or sales multiples, that provide guidance as to value.
The size and scale of the events arising due to COVID-19 are such that this approach will not work for the foreseeable future. Valuation theory indicates that the most technically correct valuation approach is the discounted cash flow (DCF) methodology. This approach assesses value based on future cash flows. Using this approach the Valuer could attempt to model the financial impacts of COVID-19 on the business.
While the approach is sound, putting it into practice in a meaningful way is not without its complications. Key inputs for any such an approach would include:
- How long and to what extent will revenues be reduced due
to COVID-19?
- What challenges the business may face converting debtors, work in progress and stock to cash?
- What costs savings/deferral might be available during the
downturn?
- What government assistance will be available to defray business costs
- After the restrictions from COVID-19 have lifted, how long will it take for economic activity and the business financial performance to return to normal, if ever?
- What opportunities exist for the business during the COVID-19 restrictions and after?
The International Private Equity and Venture Capital Valuation Board has produced a very useful paper on some of these considerations here.
Regardless, many of these inputs are simply unknown and the obvious question arises, how does the valuer minimise the uncertainty?
This question can be answered in two parts. Firstly, the exercise of sound judgement and expertise by the valuer. Secondly access to reliable information from the business being valued as well as what is happening in the economy more broadly.
We are having many meaningful discussions with clients about how the crisis is impacting them, the steps they are taking to deal with it, as well as how their financiers are viewing requests for assistance and the framework the financiers are using to make those decisions.
All of this will assist in building a model of a business’ future cash flows.
Such a model would also highlight whether it will be a challenge for the business to survive until economic conditions improve. Considerations of value may well be moot where the business has a weak balance sheet or is unable to obtain support from shareholders or financiers.
Ultimately however one has to accept that any valuation made today is subject to greater uncertainty than one produced at the beginning of 2020.
Where that uncertainty is so significant the only option, if circumstances permit may be to defer an assessment of value.
However, a DCF approach can help manage the uncertainty and provide a transparent means to assist where deferral may not be an option or the process will not allow it. Some clients may prefer to reach a resolution now, seeking to minimise the perceived risk of what may happen or because they see an opportunity to settle at a reduced value by taking on what they consider acceptable additional risk. Listed share price movements over the past month illustrate that uncertainty is no barrier to effecting a transaction.
Further information that would assist the usefulness of a discount cash flow approach (at least in the short term and where we are dealing with a six to nine month window of disruption) is a value of the business before the effects of COVID-19. In practice this could be asking for a value as at 31 December 2019.
The two answers would in effect be bookends as to the business’ potential value and would allow those negotiating an outcome a range to work within.
Key takeaways
- A capitalisation of future maintainable earnings approach is likely to have less relevance in the current environment for SMEs;
- A DCF approach would be more appropriate to assess value;
- There are a number of crucial factors that need to be considered when undertaking a DCF valuation;
- The date of valuation will impact the approach to value; and
- A pre-COVID-19 and a current valuation opinion may assist negotiations.
