Implications of COVID on Valuations for Financial Reporting
13 May 2020
The pandemic COVID-19 outbreak and subsequent lockdown has severally affected global economies which has resulted in business disruption, volatility and significant fall in revenue of the companies worldwide. Valuers while doing valuation for financial reporting or other purposes are required to take impact of this significant global event and arrive at fair value after due consideration of various factors affecting the same.
The implications on business valuations centres around current impact faced and the uncertainty of the likely future impact of COVID-19 on the business earnings and cash flow generation capabilities and also the timing of the recovery from the impact of COVID-19 on businesses. These difficulties have already reflected in the market such as – (a) the public equity markets is highly volatile; (b) a number of announced transactions has been put on hold and (c) a number of fund raisings activities and IPOs have either been deferred.
The traditional approaches which Valuers generally use to value businesses will need to make certain adjustments for COVID-19 and hence need to be carefully reconsidered in the current environment. Some levers that needs to adjust when re-pricing valuations of businesses:
1. an adjustment on the timing and growth on projected future cash flows or earnings of the business
2. an adjustment in cost of equity or discount rate used to discount the projected future cash flows
3. an adjustment to the multiple selected to capitalize the earnings
4. an excess volatility adjustments based on observed market earnings yield
5. an adjustment over liquidity or marketability discounts
6. combinations of all of the above
Adjustments to Future Cash Flows– As the future cash flows of any business will be affected by the current pandemic COVID-19 crisis, the future cash flows will therefore require some adjustments. To factor-in the impact of pandemic COVID-19, Valuer needs to access following points: (a) how deep will the impact be (Hit); (b) how long will the hit survive (Duration) and (c) how frequently do hits occur (Frequency)
(a) Hit – the hit or dent on cash flows for any business will depend on a business’ dependency on international trade, products and services provided in terms of essential or discretionary, effectiveness and nature of supply chain etc.
(b) Duration – At this stage, it is not possible to predict but considering current market commentary, COVID-19 may have an impact of 3 and 18 months. However, afterwards the duration to revive or come back in normal situation may vary based on business model, stage of the Company and several other internal/external controls.
(c) Frequency – events with this level of impact on the market are relatively rare. Looking back over the last two decades for an approximation, there have been two or three other significant market events. The occurrence rate needs to be factor-in while valuing event impacted business.
In situations where business is heavily impacted and where the cash flow outcomes are uncertain, the possible scenarios of cash flow outcomes should be modelled and probability weightings needs to be applied to those expected cash flow outcomes. This will also ensure that valuation outcomes are not dependent on general assumptions which underpin any particular fixed forecast set of cash flows upon occurrence of possible hits.
Adjustment to Discount Rates– The use of the currently impacted and declining yields on long-dated Government bonds as a proxy for the risk-free rate to determine the cost of equity under the CAPM framework would conclude a reduction in the cost of capital and hence the discount rate. Valuers needs to carefully examine this assumption in the current market. The current volatility in global equity markets indicates that the risk of investing has increased, not decreased due to the emergence of the impact of pandemic COVID-19. To capture this, a generic ‘COVID-19 risk premium’ (CVRP) could be applied to the cost of equity for temporary adjustment of discount rates to factor in the uncertainty inherent in unadjusted cash flows.
Adjustment to the Multiples in Earning Capitalization Approach– Observing changes in the earnings yield of listed companies gives an indication of the change in cost of equity across the different market sectors, thus in implied reduction in multiple would be required to adjust the impacted risk premium.
Adjustment of Excess Volatility based on Observed Market Earnings Yield- Since 31 December 2019, the level of volatility observed in the market (measured by the VIX index) has nearly doubled. Whilst not a perfect science, to translate this into a risk premium, these higher levels of volatility would have a short term impact on the cost of equity. Assuming that COVID-19 impacts volatility for say, 6-18 months, we need to estimate the impact on equity IRRs based on a 10 year time frame/outlook and adjusted the risk premium to account the same.
Adjustment over Liquidity or Marketability Discounts–Discounts over Liquidity or Marketability can be applied while valuing unlisted equities on such events where it is deemed that the investment would take a period of time to sell, or would otherwise require a discount to be applied to its fundamental value, in order to attract a willing buyer.At the current levels of uncertainty and volatility in the global market, it is reasonable to assume that a potential buyer would be hesitant to pay a full fair price. The size of a liquidity discount is impacted by the time over which the asset becomes illiquid, payment of dividends over that period and the level of volatility of the underlying equity
The COVID-19 will continue to pose significant impacts on the valuation of businesses in the short to medium term. Valuers are therefore required to carefully re-consider the traditional approaches to valuation in the current environment and also need to determine whether the financials available to them are adequate for the purpose and what adjustments, if any, should be made to earnings and cash flow forecasts, earnings multiples or discount rates.
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