May 22nd, 2020
Business Valuations in COVID-19 World
Author: Eric J. Rollinger, Devin N. Uqdah
In a matter of months, COVID-19 has had lasting effects on the economy and businesses requiring business valuators to consider its impact. On January 20, 2020, China recorded the first confirmed case of COVID-19. By January 30, 2020, the World Health Organization (WHO) officially determined the COVID-19 outbreak to constitute a Public Health Emergency of International Concern. On March 11, 2020, the WHO declared COVID-19 to be a pandemic.
Valuation dates are dictated by statute and/or case law precedent. Whether the date of valuation is before or after December 31, 2019, has important ramifications for a business valuation. Generally, a valuation analyst should consider only circumstances existing at the valuation date. Therefore, a valuation date as of December 31, 2019, would not consider the effects of COVID-19, because the first confirmed case had not yet occurred. In contrast, a valuation date as of March 31, 2020 would consider the ramifications of COVID-19’s effects on the economy and business, because the existence of the COVID-19 pandemic was known or knowable by that date.
Business valuations generally utilize a market, income, or asset approach to determine value, and each approach may be affected by COVID-19. Two of the most common market methods are a Price-to-Sales method and Price-to-Seller’s Discretionary Earnings method, which utilize sales revenues and earnings respectively applied to a multiplier to determine value. However, actual and expected sales revenues and earnings may have decreased due to forced COVID-19-related closures or decreases in customer demand. Barbershops, hair salons, non-essential medical care, and dine-in restaurants have mostly been forced to temporarily cease operations. Many businesses forced to create virtual offices have seen a decrease in sales revenue and earnings while other industries, like grocery stores, have generally seen an increase in business due to stay-at-home orders and restaurant closures. These changes to sales revenues and earnings, especially if determined to be temporary, can result in indicated values based on comparable sales transaction multiples from previous periods that do not reflect the current COVID-19 environment.
We are unsure how long the COVID-19 pandemic will last. Will the restrictions end soon? When they end, will customers quickly return and earnings/cash flows rebound to what they were before COVID-19? Will businesses that saw an increase in earnings/cash flows continue to see the increase after restrictions are eased? The answers to these questions are difficult to determine. Therefore, valuing businesses under the most common income methods such as Capitalization of Cash Flows and Discounted Cash Flows methods are materially affected. A business’s past cash flows and projections of future cash flows may no longer be reliable or reflective of the future resulting in values that are potentially inaccurate as a result of COVID-19.
Valuations may be more accurate utilizing an asset approach such as an Adjusted Net Asset method, because assets, unlike forecasted earnings, either exist or don’t. However, an analyst must be mindful that assets can be impaired or cause the business to have a different discount for lack of marketability (DLOM) as a result of COVID-19. A DLOM reflects the absence of a recognized market for equities and accounts for the fact that a closely held business is generally not readily transferable.
Additionally, with the increase in the need for cash by many businesses as a result of COVID-19, the reliance on financing from banks for operations and expansion has grown. Interest-bearing debt may be increased to pay employees and other fixed continuing expenses. For majority and minority interests in companies, DLOMs may have increased due to liquidity issues in the market.
In conclusion, valuation dates, methods, and discounts are not set in stone by courts. The courts rely on experts to analyze businesses and assets in adherence to the law to properly determine value. The COVID-19 pandemic affects the value of most businesses, and it is paramount to consider its effects to determine proper values.