Ongoing uncertainty in the market poses challenges to businesses in revaluing their investments and assets. Euan Hamilton outlines some of the key considerations when accounting for uncertainty in financial forecasting and business valuations.
Both financial forecasting and business valuations are subjective exercises and become more complex when markets are volatile and benchmarks quickly go out of date.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. Some key topics to look out for are:
Updating financial forecasting
Cash flow forecasting continues to be a key issue for businesses. 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 short-, medium- and long-term financial forecasting?
Is the model robust and flexible enough to perform a regular re-forecasting exercise as new information becomes available?
Having a robust and defensible forecast is the starting point of the valuation and will flow into the inputs and judgements around discount rate and premium discounts.
The principles guiding the selection of a valuation approach remain unchanged and valuers should continue to follow best practice guidelines from International Private Equity and Venture Capital Valuation (IPEV) and similar sources.
Where possible, approaches should remain the same as previous valuations. However, previous financial forecasting models may no longer provide a reliable valuation conclusion and care should be taken to ensure that assumptions have been appropriately updated to account for current market data, or lack thereof. It is more important than ever to consider multiple approaches to triangulate fair value.
The economic environment poses certain challenges in completing a meaningful market approach.
1 Your subject company may differ from your comparable companies in terms of both business offerings and financial stability
2 Market multiples are typically calculated using the current market value compared to a lagged financial metric, which will not truly reflect the expected run-rate
3 Forward earnings expectations remain uncertain based on the new economic environment and therefore forward multiples may not be entirely meaningful
Care should be taken to ensure that the impact is not double-counted by applying a low run-rate metric to an artificially low multiple.
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, which may ultimately dry-up in the coming months. Other companies may need to consider potential supply chain disruptions.
One of the key drivers of the income approach is discount rates and various elements are impacted by current market conditions.
Government bonds are arguably no longer reflective of risk-free rates, which have fallen due to a flight-to-quality
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) and incremental borrowing rates (IFRS 16)
Debt-to-equity will shift based on decreases in market cap for comparables
Where possible, the market value of debt should be considered to ensure that the ratio is not distorted. It is worth noting that D/E 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.
One clear impact of the current crisis is on companies’ impairment analysis. Companies should act sooner rather than later to assess the impact of a triggering event on their carrying values.
When and what was the triggering event?
What were the expectations at that time in terms of the period of the downturn and recovery?
Impairment analysis is likely to be a key area of audit scrutiny in forthcoming reviews.
Where possible, valuation models should be calibrated to the most-recent fair-value transaction. This ensures that the inputs to the model are aligned with market participant expectations, ie, forecasts, discount rates, premium discount to the comparable companies.
For a few companies that may be less exposed to the current market shocks or, indeed, may be benefiting from increased demand, calibration may remain a useful tool for valuation. As usual, changes in judgements should be supported by commentary and available market data, where possible.
However, for many companies, the question now arises as to whether the calibration is reliable anymore.
The use of calibration is dependent on the broader context of the latest fair value transaction holding true. This will need to be carefully assessed on a case-by-case basis.
Funds will need to place extra focus on their unquoted investment valuations for the foreseeable future. Careful consideration needs to be given to the impact on each portfolio company and the key will be to ensure that the reported valuations are meaningful to investors, who will be focusing on this process far more.
Investors should be wary of:
consistent recording by general partners (GPs) of investments at cost price or 'price of recent investment'
lack of movement in the net asset value (NAV) from December to March.
While some may view it purely as an accounting issue, the NAV should be decision-useful to investors. A stale NAV may not be reliable and may be reflective of a passive approach to valuation. In such cases, investors should take this opportunity to engage with GPs on their valuation process and be proactive in identifying changes in value. It may also be worth considering an increased frequency of NAV reporting, as the next six months are likely to remain volatile.
If you would like to discuss financial forecasting and business valuations further, get in touch with Euan Hamilton.
The IPEV board has released special guidance to clarify treatment of investment valuations during this time