How COVID-19 is Re-Shaping Company Valuations
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How COVID-19 is Re-Shaping Company Valuations
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By Faith Nyabuto, Analytics Lead, Botho Emerging Markets Group
September 25, 2020
COVID-19 containment methods may have curbed the spread of the virus, but restrictions have hit business operations hard in developed and emerging markets alike. Due to supply chain disruptions and weakened demand, businesses continue to face extended periods of uncertainty in their operational performance and, in some cases, continuity. While businesses of every size have been affected, the impact on micro, small and medium enterprises (MSMEs) has been pronounced — over 67% of MSMEs in a recent global survey indicated that they were strongly affected, compared with 40% of larger companies. In the face of this uncertainty, investors now struggle to evaluate opportunities and place fair value on potential investments. As new investments slow down, ongoing investment discussions are at a crossroads: investors must reconsider valuations or adjust key investment terms to account for the realities of COVID-19.
Distorted perceptions of market and company-specific risks from the effects of COVID-19 have increased the attention on investors and company management teams’ valuation of potential investments. Investors are keen to understand potential risks and returns to inform their investment decisions, oftentimes expecting high returns to account for heightened risk. On the other hand, management teams require reliable estimates of their companies’ value to provide them with a perspective on pricing for investment consideration, in addition to attaining a view of where they stand relative to their peers. As investors assess company values, they need to bear in mind the expected impact of COVID-19 on key inputs to valuation models, such as cash flow forecasts and market factors that influence discount rates.
The current market volatility shaping both equity and debt transactions has significant implications on perceptions of risks on assets and investments. Market data in unstable conditions become problematic to use and affect the quantification of necessary adjustments. As a result, managers have to decide whether to make adjustments to current period and projected earnings based on market sentiment, especially in light of constantly changing data. Given that valuation inputs such as discount rates and growth rates are impacted by economic shocks to varying degrees, it is important to document the nature of information flowing into the valuation and show how it aligns against a company’s financial metrics. Understanding the specific purpose of valuation and how relevant inputs will be overlayed with a company’s commercial and financial attributes is useful when deciding how much of the market’s volatility should be ‘imported’ into the valuation.
Impacts on working capital caused by shifts in demand and disruptions in the supply chain cause changes in a company’s cash flows, another key element in company valuation. Whereas businesses in a few sectors such as healthcare and information technology have generally benefited from the pandemic, most other sectors have been negatively impacted and companies continue to face cash flow problems. In China, nearly 85 percent of small and medium-sized enterprises (MSMEs) would run out of cash within three months, and two thirds would run out of money in two months should the crisis persist. Similarly, 79 percent of manufacturing companies surveyed in Kenya reported that they were unable to meet their operational costs due to cash flow constraints, with 86 percent of MSMEs facing the same challenge. The immense uncertainty in cash flow levels in the near and medium-term makes it essential for companies to re-forecast and model prior estimates while considering alternative scenarios in the forecasting process, including variations in the duration and magnitude of the crisis. An iterative process to reflect the changing risk and uncertainty in cash flow forecasts given new circumstances in the wake of COVID-19 is also useful.
To structure investments efficiently, stakeholders should adopt a multi-pronged approach to mitigate externalities from COVID-19. Companies must institute a robust and flexible valuation that allows for seamless use in periods of stable market conditions, as well as during uncertain times. For investors, it is essential to evaluate both quantitative and qualitative factors (such as company management capacity, governance structures and operational efficiency) in the valuation process. Giving consideration to both intangible and concrete elements provides investors with a comprehensive perspective of the company, allowing for determination of an appropriate fair value—a price agreed upon by a willing buyer and seller, assuming both parties are knowledgeable and enter the transaction freely—for a subject company. In cases where an industry is heavily impacted by COVID-19, combining the average of the last three years’ performance with reasonable forecasts is ideal. Where there are concerns over the attainment of forecasts, contingent consideration structures, more commonly known as “earn-outs” or “claw-backs” can be used. In such an arrangement, a portion of the investment amount is deferred to a future date and paid out by an investor to a company upon the latter’s achievement of certain performance metrics agreed upon at the outset. Such structures allow for the investor and company to share in the valuation risk and gain from future upside.
As we head towards 2021 with businesses having experienced more than six months of disruption, fair COVID-adjusted valuations are more important than ever. While it is substantially more difficult to arrive at a fair value during these unprecedented times, it is not impossible. Traditional valuation methods are still relevant, but they involve more nuanced application than before, with additional consideration taken for the expected duration and magnitude of the crisis. Ultimately, valuation is more an art than a science and parties to an investment decision would need to find a “middle ground” reflective of their risk perceptions and future outlook.