Knowledge and Insights

Business Valuation Considerations In The Midst Of An Economic Downturn

The effects of the COVID-19 pandemic have manifested in new ways of working virtually, historic unemployment levels, increased divorce rates, and many other evolving ways.[1] Closely held businesses have experienced unforeseen profitability growth or decline depending on the industry and other unique attributes of a specific company. In valuing a privately held company, the COVID-19 pandemic has enhanced the focus of the risks associated with cash flow realization, the factors affecting a company’s cost of capital (discount rate), and growth.

Fundamentally, the valuation of privately held companies relies on the application of the asset, income, and market approaches.[2] The asset approach, also known as the cost approach, has an emphasis on the balance sheet and determines the difference between the market value of a company’s assets and liabilities. The market approach relies on comparable companies and transactions. The income approach determines a company’s value based on income and risk, which requires projected cash flows or other future expected economic benefit streams, discount rate(s) and growth rate(s).

In today’s current economic climate, the income approach may be emphasized in many settings since the market approach may lack current data, and the asset approach in many instances is probably not appropriate when the operating results are more indicative of value than tangible net assets (more emphasis is placed on the asset approach for investment and holding companies).

Income Approach

In consideration of the income approach, a key input is projected debt-free net cash flow (DFNCF).[3]  Once the dust starts to settle with the COVID-19 pandemic, your company may expect recoveries that are V-shaped, U-shaped, W-shaped or L-shaped. There may also be concurrent scenarios of expected recovery with varying degrees of probability (more likely or less likely expected financial projections). These recovery periods and underlying assumptions need to be communicated with the valuator.

For mature companies with historically stable growth characteristics, the direct capitalization method of the income approach may be used. However, when variable future cash flows are expected in the short-term due to the economic effects of COVID-19, preparing a discounted cash flow (DCF) model may be appropriate. A DCF model would incorporate the short-term variable expected cash flows, and then a return to sustainable, stable growth in a year or more.

When evaluating the risks associated with cash flow realization in this current environment, it is integral to enhance the due diligence of the specific company, its industry, the local, national and world economies, and other impacts on owners, employees, customers, suppliers, as well as other key players. In the process of incorporating interviews with the client, research, and analysis in the business valuation, it is important for the valuator’s report to document the process and methods utilized and report reasonable, well-informed, understandable, and defendable findings in compliance with applicable professional and governing standards.[4]

Market Approach

In consideration of the market approach, the current COVID-19 environment may hinder comparable company metrices and transactions for your specific business. Valuators may be presented with historical market data that does not necessarily reflect the current market since merger and acquisition activity has been delayed with the lowest level of deal volume being reported since the Great Recession ended in 2009, which was the longest economic downturn since World War II.[5]

AICPA Guidance

In June of this year, the American Institute of Certified Public Accountants (AICPA) released a set of FAQs to help adjust business valuations based on the Coronavirus Aid, Relief and Economic Security (CARES) Act.[6] These FAQs provide guidance to valuators when evaluating businesses that received funding or other benefits under one of the CARES Act provisions, the Paycheck Protection Program (PPP), Emergency Economic Injury Grants/Economic Injury Disaster Loans (EIDL) and the Small Business Debt Relief Program. Tax law changes are also addressed.

The AICPA’s FAQs speak to the cash businesses received and provide guidance for adjusting the one-time inflows in a valuation model. Considering the possibility certain loans could eventually be converted to grants, the FAQs mention capital structure and cost of capital adjustments that may be warranted. Taking into account the market approach, the FAQs provide direction for adjusting multiples of comparable companies that received benefits under CARES Act provisions.

Overall, valuation models need to consider the effects of one-time benefits and be reflective of the expected ‘new normal’ of operations, capital structure and cost of capital for the subject company. The preparation of a business valuation is a combination of art and science, and the reality is no one knows with certainty when we will return to a pre-COVID 19 economic outlook level. Conducting requisite due diligence, deploying well-reasoned and supported cash flow projections, and, if possible, identifying market comparables reflective of the current economic climate are key. Also consider, with reliance on AICPA’s FAQs, how recent government initiatives to curb the economic effects of COVID-19 have affected your business in order create cash flow and capital structure projections that reflect short-term, middle-term and long-term expectations.

Mercadien’s Forensic and Litigation Support Services Group can help you through the process of business valuation and determine what approach is best for you and your company during these uncertain times. We can help you conduct the proper due diligence, mitigate risk, perform economic damage assessments and calculations, as well as offer practical advice for your business. Contact me at jbaresciano@mercadien.com or 609-689-2386 with any questions or to learn more about how our team can assist you.

DISCLAIMER: This advisory resource is for general information purposes only. It does not constitute business or tax advice, and may not be used and relied upon as a substitute for business or tax advice regarding a specific issue or problem. Advice should be obtained from a qualified accountant, tax practitioner or attorney licensed to practice in the jurisdiction where that advice is sought.

[1] https://legaltemplates.net/resources/personal-family/divorce-rates-covid-19/

[2] This article provides a high-level overview of valuation concepts and does not address the numerous distinctions specific to each valuation.

[3] Other future expected economic benefit streams can be capitalized such as net income and earnings before interest and taxes (EBIT).

[4] This article does not address the numerous reporting nuances specific to each valuation engagement.

[5] https://www.forbes.com/sites/tedknutson/2020/07/07/ma-activity-suffering-more-from-covid-19-than-europe-and-asia/#5d1bf9db2f7d

[6] https://www.aicpa.org/interestareas/forensicandvaluation/resources/businessvaluation/valuation-considerations-related-to-cares-act.html