Knowledge and Insights
The uncertain economic environment during the COVID-19 pandemic has made business valuation practitioners questioning the more historically utilized inputs. Many companies have experienced unforeseen growth or decline, depending on the industry and other unique attributes of those companies. The pandemic has enhanced the focus of the risks associated with cash flow realization, the factors affecting cost of capital (discount rate), and growth. The legwork in identifying the “known or knowable” as of the valuation date, — a vital concept for business valuations — has increased as more sources of information, aggregate views, and sensitivity analysis may be required to arrive at an unbiased narrative and conclusion.
The American Institute of Certified Public Accountants (AICPA) released a set of frequently asked questions (FAQs) to help business valuations adjust to the Coronavirus Aid, Relief, and Economic Security (CARES) Act. These FAQs provide guidance for practitioners 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, and the Small Business Debt Relief Program (SBDRP). 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 that certain loans may convert 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 the multiples of comparable companies that received benefits under CARES Act provisions.
The AICPA also released the VS Section 100 subject event toolkit, which focuses on questions regarding subsequent events “in times of high uncertainty or rapidly changing economic, financial, market conditions.”
The valuation of closely held companies relies on the application of the asset, income, and market approaches. The asset approach, also known as the cost approach, emphasizes 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 rates and growth rates.
In the current economic climate, the income approach may be emphasized in many settings since the market approach may lack current data. 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 real estate holding companies).
With the market approach, the economic and financial environment may hinder comparable company metrices and transactions since private company mergers and acquisitions (M&A) have been delayed. Accordingly, practitioners may be presented with older market data that does not necessarily reflect the current market or a forward outlook. While the difficulty in identifying market comparables and interpreting them has increased, avoiding the market approach altogether is not warranted.
When variable future cash flows are expected in the short-term due to the economic effects of the COVID-19 pandemic, preparing a discounted cash flow (DCF) model from your client’s forecast 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. As the pandemic lingers and its economic, financial, and market effects are still being felt, companies may have 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). The recovery periods and underlying assumptions of your client need to be communicated and vetted for reasonableness.
For companies with expected stable growth, the direct capitalization method of the income approach may be used for a single period instead of the DCF model.
When evaluating the risks associated with cash flow realization in the current environment, it is integral to enhance the due diligence of the company, its industry, the local, national and world economies, and other impacts on owners, employees, customers, suppliers, and other key players. When incorporating interviews with the client, research, and analysis in the business valuation, it is important for the practitioner’s report to document the process and methods used and report reasonable, well-informed, understandable, and defendable findings in compliance with applicable professional and governing standards.
Overall, ensuring that the entire story of a closely held company is interpreted correctly in the pandemic environment is key, and it requires creativity and flexibility in the form of reassessing what you have always done, more sources of information, vetting management forecasts, documentation, removing subjectivity, and sweat equity.
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 email@example.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.