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Valuations in lockdown: accounting for uncertainty

Tomas Freyman Tomas Freyman

The current market turmoil poses challenges to businesses in re-valuing their investments and assets. Both forecasting and valuation are subjective exercises and become more complex when markets are volatile, and benchmarks quickly go out of date. The key priority is to produce an output that is meaningful to stakeholders based on robust and defensible judgements, explains Tomas Freyman.

Understanding and forecasting uncertainty

Many businesses are spending nights and weekends frantically trying to get a handle on what the rapid changes in their business mean on their cashflow. Some questions to consider are:

  • What are the direct and indirect impacts on the business or assets under review?
  • How can this be captured in the short, medium- and long-term forecasts?
  • Is the model robust and flexible enough to perform a regular reforecasting exercise as new information becomes available?

Valuation approaches

The principles guiding the selection of a valuation approach remain unchanged. However, previous models may no longer provide a reliable valuation conclusion and care should be taken to ensure that the approaches appropriately account for current market data, or lack thereof. It is more important now than ever to consider multiple approaches (and considerations as set out below) to triangulate fair value.

1 Market approach:

  • Differences between the subject company and comparable companies may impact the selection of multiples.
  • Multiples are based on lagged metrics (ie, LTM EBITDA) which may not reflect the current run-rate.
  • There is a lag in analysts updating forecasts for the comparable companies.
  • Care should be taken to ensure that the impact is not double-counted, ie, applying a low-run-rate metric to an artificially low multiple.

2 Income approach:

  • The impact on short- and long-term cash flows needs to be estimated. It is important not to rely only on current run-rates. Special attention should be given to historical results, expectations of cash flow during the economic downturn and beyond and the expected timeline of the economic decline.
  • Some companies may experience a short-term boost to sales that may ultimately dry-up in the coming months. Other companies may need to consider potential supply chain disruptions.
  • Discount rates (as further explained below) may need to be reconsidered,

Discount rates

Discount rates are one of the key drivers of the income approach and various elements are impacted by current market conditions:

  • Government bonds are arguably no longer reflective of risk-free rates. While these rates have fallen due to a flight-to-quality, this is offset by an increase in equity risk premium and credit spreads.
  • The impact on historical betas will depend on the period over which the beta has been calculated and the selection of market index.
  • Credit spreads have increased in recent weeks, impacting the cost of debt for both Weighted Average Cost of Capital (WACC) calculations and incremental borrowing rates.
  • Debt-to-equity will shift based on decreases in equity market capitalisation for comparable companies. Where possible, the market value of debt should be considered to ensure that the ratio is not distorted. It is worth noting that debt-to-equity ratios remain impacted by IFRS 16 and those companies which have implemented versus those who have not.

Special care should be taken in properly matching discount rates to risks inherent in any prospective information and performance risk should ideally be reflected in the cash flow forecast rather than adding an alpha (specific company risk premium) to the discount rate.

Impairment analysis

One clear impact of the current crisis is on a company’s potential impairment analysis. Companies should act sooner rather than later to assess the impact of a triggering event on their carrying values. Some questions to consider:

  • What is the triggering event and on what date did this occur?
  • What were the expectations at that time in terms of the period of the downturn and recovery?

The above are only some of the issues facing companies today. Our team is regularly publishing short LinkedIn articles highlighting issues as they arise. Please follow the links below or search #GTValuations on LinkedIn:

Get in touch with any member of our valuations and modelling team for more information.

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