Repricing risk in the times of COVID-19Thoughts and questions for the valuation community and interested stakeholders
Warren Buffett said, “Risk comes from not knowing what you are doing”. In volatile times like these, there are many unknowns and variables that give rise to significant valuation risks and opportunities.
Since March 2020, certain industries have been hit hard, some have demonstrated resilience and others have enjoyed accelerated growth. Industry and company-specific factors must be applied to more generic inputs to produce a sound valuation analysis. The discounted cash flow (DCF) method should be the primary approach during this period.
When markets are in turmoil, what is the meaning of “fair” in the definition of fair market value’ (FMV)? If markets were temporarily rendered illiquid and inefficient, should the prohibition against hindsight evidence be relaxed to help the valuator arrive a better valuation conclusion?
We hope this article will help you explore these and related ideas – and as always help distinguish value from price.
The COVID-19 landscape: an overview
What was known or knowable and what did the market say?
At the time of writing, some indices had rebounded to pre-COVID levels, but a second wave and subsequent volatility remain a possibility. History has shown that private markets are not as volatile as public ones, and we believe this remains true during the pandemic. Public market data during COVID, as it applies to private company valuation, must therefore be used with greater caution and professional skepticism.
The rebound of the stock and credit markets following the low in March 2020 was meaningfully bolstered by remarkable government stimulus, particularly in Canada and the US. The level of funding provided and the impact on the economic environment could not have been predicted at the outset of the pandemic. Further, at the time of writing, it is difficult to predict the level of government stimulus that will persist and its impact on corporations, industries and the macro economic climate.
Other contemporaneous factors
There were many pre-existing social, business, industry and technological trends occurring simultaneously with the pandemic; many of these were accelerated or more pronounced as a result of the pandemic. Trends such as the continued shift and greater emphasis towards online shopping, remote working and learning, the concern for sustainable environmental practices and migration away from fossil fuels. Simultaneously, there were important world events which had a dramatic impact across virtually all industries and economies, including: the Saudi Arabia/Russian oil crisis, trade issues with China, low interest rates, increasing nationalism, and ballooning sovereign debt. During the height of the pandemic, North American and European equity and credit markets were in flux and private and public deal volume was down. There have been some signs of stabilization in recent months, and deal activity has also been picking up as of late. The Canadian dollar has also rebounded to pre-pandemic levels (Table 2).
Are these trends and concerns temporary or permanent? How should a business valuator account for them? COVID-19 and other factors resulted in a sharp decrease in the GDP outlook, which is anticipated to rebound in 2021 and return to normalcy in 2022 (Table 3). Key lending rates all fell in March 2020 with no rebound to August 2020 (Table 4). At the same time, yields on corporate bonds have fallen since their high in March 2020. These factors, along with fears of a second wave of COVID-19 are real, and potential consequences of this wave and other trends and events need to be considered when determining FMV.
Acceleration of pre-existing trends – temporary or permanent?
It’s been discussed at length, but in short: depressed sales, supply chain upset, and massive layoffs for some, while others are experiencing a surge in demand and are facing new challenges as they try to scale up. We are seeing dramatically different sectoral performance and trends, but there are significant differences in how companies within the same industry have dealt with the challenges presented. Whatever the result, there is often a significant impact to FMV which cannot be overlooked, and company-specific analysis remains important.
Is it a trend? Or here to stay? COVID-19 has impacted almost all aspects of our lives:
Where are we at? Where are we going?
Overall, based on market data: the number of transactions in Canada is down approximately 40% based on a year-over-year comparison from March 1 to July 31, 2020.
The following insights are based on an informal survey of institutions, PE / VC Funds and family offices in May/June 2020 and our own observations:
Table 5 illustrates how the S+P 500 performed during past crises –it has taken two to seven years to recover in the past, far longer than the time to crash, and there may be many waves up and down before the recovery is complete.
Industry: the good, the bad, and the ugly
Not surprisingly, between mid-February and August 2020, pharma and biotech more than recovered, while energy and travel are still very depressed. It is important to remember though, that stats for any industry are just averages. Some companies will prevail through innovation, flexibility / ability to pivot, access to liquidity and other factors, while others will perform worse than their peers. Perhaps most importantly, the market is not a good proxy for intrinsic value. It does help with some directional impact, but company-specific analysis and an assessment of company-specific factors are of utmost importance.
Table 7 summarizes the evolution of multiples by industry. By May 31, 2020, multiples for sectors impacted less by the pandemic had recovered and by August 31, 2020, multiples had recovered for almost all industries. With that said, earnings were significantly down for many industries, leading to overall lower valuations (with some exceptions). Trading multiples should be viewed with skepticism.
For example: Table 8 shows the S+P Retail Index against Lululemon – which many of us have been sporting as our new remote working attire – versus Under Amour, a brand that was struggling pre-pandemic and has seen an accelerated negative trend:
This further exemplifies that the struggles companies experienced pre-pandemic were further exacerbated during the pandemic.
Value definition and the use of hindsight
When markets are illiquid or inefficient, it is important to understand how ‘fair’ modifies the definition of FMV and whether there is legitimate use of hindsight beyond the testing of the reasonability of assumptions as permitted by the hindsight principle.
When the target business and the valuation date circumstances are more uncertain than normal, assumptions in notional valuations will be equally uncertain. The more risk in the business generating the cash flow, the more risk that the valuation result will be flawed.
What is ‘fair’?
How does the word ‘fair’ modify ‘market’ and ‘value’ in times of turbulence and market volatility? Are quoted market prices indicative of a fair value and / or fair market? Case law certainly opens the door that quoted market prices and the volatility of the market are not necessarily equal to FMV or fair value. Several definitions of FMV suggest market data from consistent markets should be given much more weight than when drawn from markets in flux. One definition of FMV is “the value obtained in a normal market, that is,
a market which is not disturbed by unusual economic factors and where vendors, ready but not too anxious to sell, meet with purchasers ready and able to purchase.” To further quote case law: “market price must have some consistency and not be the effect of a transient boom or a sudden panic on the market”.
Will the pandemic’s impact on stock prices be considered a “transient boom or sudden panic” on the market? Or a long-awaited correction? As earlier discussed, it is important to distinguish “transient boom or sudden panic” effects from more permanent effects for which the pandemic was only a catalyst. Price volatility alone does not preclude a market from being deemed consistent; a distinction can and should be drawn between normal volatility – say in the technology, pharma or mining industries as the result of a resource discovery or significant innovation – in contrast to a “transient boom” based on fear mongering and emotions as might have been evident during the pandemic. A global, panic driven sell-off may result in selling prices that are not equal to FMV.
What does the case law say about hindsight?
“Hindsight or retrospective evidence is the consideration of facts and events occurring after a specific date in question, such as a valuation date or breach date”.
Jurisprudence validates the hindsight principle: “I expressly rejected the validity of hindsight as probative of fair market value at a given date and took nothing that occurred after Valuation Day into account.” In notional business valuations, courts have generally held that hindsight evidence cannot be used except to test the validity / reasonableness of assumptions at the valuation date and/or obtain a better understanding of facts or conditions which are known or knowable at the valuation date – i.e. the “hindsight principle”.
However, in the rare circumstances where there is no other data available, exceptions have been made: “Since the market for artwork experienced such significant changes within a short period of time before and after the financial crisis, the Court found that such factors must be taken into account in determining an appropriate value for the three paintings.”
When there is a lack of good quality data, is hindsight a means of mitigating an inefficient market? If so, it’s appropriate use might be limited. Consider the following:
- How long is the period, post valuation date, during which it is appropriate to consider hindsight information? We believe a few months may be permissible. For example, for March to May 2020 valuation / damages dates, the subsequent market rebound might be a permitted use of hindsight.
- When valuing a business at a Spring valuation date, could the valuator rely on hindsight data from the Fall to confirm “second wave” effects? It seems to us that in the Spring of 2020 the second wave was a real risk that had to be assessed as one could best do at that time. However, the occurrence (or not) of an actual second wave, is too long past the Spring valuation date to be considered in the valuation.
For the purposes of quantification of damages, facts and information related to the period after the alleged wrongdoing is generally admissible. Damages are compensatory by nature and seek to place the injured party in the same position that it would have enjoyed but for the wrongdoing. Simply, the quantum reflects “what would have happened” less “what actually happened”. What “actually happened” will reflect events that occurred after the damages date. Therefore, it is appropriate to consider hindsight data when determining “what would have happened”. Essentially, “hypothesis should not replace history”.
Impact to methodology and cost of capital during covid-19
Where to start?
A thoughtful discussion is a good place to begin, which will help the valuator assess the impact of the pandemic on the subject business:
- The business plan – how was it updated, who was involved, was it stress tested?
- Customers and suppliers – evaluate health, pipeline, and various risks and opportunities.
- Products and services (availability, volumes, price) – consider supply chain upset, impact to
- Operations – changes to key overhead costs, impact of government assistance programs.
- Liquidity – cash runway, covenants, collateral assessment, working capital requirements.
- Profitability – when is the company expected to return to the pre-COVID-19 level of profitability? What is the expected impact on long-term profitability?
The answers to the above questions will help determine the appropriate valuation approach and point the analysis in the right direction.
Selecting an approach
We believe a cash flow-based model accompanied by thoughtful sensitivity or scenario analysis is essential when preparing a valuation in a time of financial crisis. Consider the following:
- Income Approach:
- DCF is a preferred approach but its major pitfall is a lack of good quality projections.
- Capitalized cash flow or income methods are suspect as the “normal / sustainable” cash flow
or income to be capitalized may be difficult to determine. Relevance of trailing twelve months must be carefully considered and synchronized with the right multiple or discount rate. It is almost impossible to capture the potential volatility of the recovery to “normal” using capitalization rates or multiples.
- Some analysts are assuming a return to ‘normal profits’ within six to 24 months and discounting back to the valuation date, specifically adjusting for interim profit / loss. While this approach seems reasonable, it introduces a further element of uncertainty.
- Market Approach is still appropriate in the current environment, however, anomalous inputs, the thin market, and comparability must be very carefully considered.
- Asset Approach often relies on historical data which may be outdated. Further, use caution with reliance on reports qualified due to the pandemic and related matters.
Effects of depressed cash flow
Does one or two poor years matter? In a time where buyers are seeking discounts and quality sellers are holding firm on price, who has it right? Table 9 illustrates how one or two years of poor performance can have a significant downward impact on value. The impact on equity value would be much more significant
if the business was levered.
These are simple scenarios for illustrative purposes. Scenarios should thoughtfully contemplate various economic, industry and company-specific outcomes including access to liquidity to fund potential negative cash flows.
Access to liquidity is key and could have a significant impact on value. Access to financing was initially expected to be very constrained but governments have provided enormous liquidity to the debt markets and corporate lending to larger entities has been much easier than anticipated. Lending to smaller businesses has been and was predicted to be more sporadic and constrained.
Impact on rates of return to be used in business valuations
Both sector and company-specific factors must be considered. Many thought leaders continue to use spot interest rates to determine rates of return but have offset this reduction with an increase to the equity risk premium (Table 10). Despite decreased spot interest rates, spreads have increased, resulting in a higher cost of debt. As a result, for some companies but not all, discount rates have trended higher.
Consider using a lower level of “optimal” debt to allow for a greater operational financing cushion. It is best practice to adjust both the cash flow and the rates of return and ensure that the two are properly calibrated to capture risk appropriately.
Marketability discounts are likely impacted by covid-19, at least in the short-term
Each investment needs to be assessed using specific facts; and when assessing marketability discounts for minority interests, context is very important. Since February 2020, we believe, in general, that marketability discounts have increased as a result of the factors below – albeit partially offset by a lower risk-free rate of interest:
- Decreased access to financing for the underlying business and the purchase of the minority position itself.
- Decreased M+A activity and a reduced pool of willing buyers.
- Increased supply side of secondary investments as institutions seek to divest to rebalance and/or meet regulatory requirements.
- Reduced expected profitability, cash flow and longer realization timelines.
- Increased perceived risk and demand of higher returns.
Notwithstanding the above, over time, a prolonged period of low interest rates, a lack of investment opportunities, large amounts of investable cash available and comfort with risk may moderate the marketability discount range.
Whether for a notional or transaction-oriented valuation, companies and valuators should take the time to prepare and assess the company’s projections to understand how the company is most likely to weather the pandemic. While market data may be directionally helpful, deep forward-looking company-specific analysis is key to arriving at a reasonable and thoughtful conclusion.
This article was written by Richter LLP’s Business Valuation and Dispute Advisory Group.
Contact Person: Alana Geller, CPA, CA, CBV, CFF
The opinions expressed in this article are solely those of the authors and not necessarily those of Richter. Richter does not guarantee the accuracy or reliability of the information provided herein and the views and opinions expressed herein may change. The information herein was compiled as of August 21, 2020 or as noted; some information may have changed since that date.
 S+P Capital IQ, based announced and closed deals with value greater than $5M, excluding real estate and resources.
 Withycombe Estate / Attorney-General of Alberta v. Royal Trust Co., 1945
 Estate of Isaac Untermeyer v. Attorney-General for the Province of B.C.,1928.
 Henderson Estate v. Minister of National Revenue, 1975.
 CBV Institute
 The Queen v. National System of Baking Alberta Ltd., 1978. Other similar cases include Holt v. IRC, 1953, Dailley Recreational Services Ltd. V. MNR, 1984, Airst v. Airst, 1998.
 Estate of Bernice Newberger, et al., v. Commissioner of Internal Revenue.
 “Is Hindsight Admissible in Business Valuation?” (Wise, Blackman, LLP, 2006)
 “The Use of Hindsight in Damages Quantification – Beware a Valuation Approach” (Steger, 1999)