How has COVID-19 affected the way your business is valued?

March 11, 2021

How has COVID-19 affected the way your business is valued?

Businesses of all sizes – and in all industries – have been significantly disrupted by the COVID-19 pandemic. And when you need to initiate a business valuation process, your business valuation professional will also face an array of challenges.

What is a business valuation?
A business valuation is the process of determining the economic value of your business, giving you an objective estimate of the value of your company.

Typically, a business valuation happens when an owner is looking to sell (or gift) all or a part of their business, or merge with another company. Other reasons include settling a business owner’s estate, obtaining debt or equity financing to expand your business, adding or buying-out shareholders, and business or personal litigation.

What are the specific impacts of COVID-19 on the business valuation process?
Traditional valuation methodologies and approaches need be tailored to the unique circumstances of this global event. While there are no hard-and-fast rules or procedures for valuation professionals to appropriately estimate value in the COVID-19 age, your business valuation professional knows that the following items must be considered in order to arrive at a realistic estimate of value:

Must have: Subject Company Risk Assessment
Your business valuation professional must estimate your business’ value by executing a thorough risk assessment of the subject company.

The pandemic has changed the risk profiles for many companies – and the operations of certain businesses, including retail and restaurant operations, have been severely hampered. At the same time, other businesses, including certain construction businesses, medical supply companies, etc. have seen their revenues and profits increase dramatically since the start of the crisis.

It will be vital to start with a risk profile of YOUR business.

To deliver a comprehensive valuation, the valuation professional must provide a detailed risk profile of the business as of the date of valuation. Factors normally considered as part of a subject company risk assessment for a business valuation include personnel changes, limitations on management depth, changes in the subject company’s customer and/or supplier base, sensitivity to raw material price changes, among others.

Must use: Capitalization / Discount Rate
The risk profile developed for your company will be incorporated into the estimation of the capitalization rate (or discount rate if projected financial information is used) if an income approach analysis is performed.

What is the capitalization rate? It is an estimation of the rate of return that a hypothetical investor would require if they were to invest in your company.

This rate is a key driver in the development of value of your business. Many of the inputs used in developing the capitalization rate are published data based on historical economic performance (typically based on U.S. Treasury security yields and equity market performance), but a premium based on the specific risks of the subject company is also included as part of the estimation of the capitalization rate.

Due to the pandemic-induced economic downturn, many of the economic inputs used to calculate the capitalization rate have changed - and thus a premium for the specific risks of your company must be estimated thoroughly to ensure that a realistic capitalization rate is utilized to estimate value.

Must consider: Normalization Adjustments
Your valuation professional will consider the need for adjustments to income or expense items that may be non-operating or non-recurring in nature, when reviewing the historical or projected financial information of your business. These adjustments are referred to as normalization adjustments.

The adverse economic impacts of the pandemic have resulted in companies realizing income that may be non-recurring in nature along with many one-time expenses. These income and expenses must be analyzed meticulously, and those items that are deemed to be non-recurring or non-operating must be eliminated from the valuation analysis to provide an estimate of your business’ future earnings capacity based on economic reality.

Must consider: Weighting of Periods
Your valuation professional, utilizing either the historical or projected future income streams of your business, must consider the need for weighting of the financial results of 2020.

Valuators often average the results of three- or five-years’ worth of historical financial information to obtain an estimate of the future earnings capacity of a company through a full business cycle. The financial results of the periods impacted by the pandemic may be an anomaly for your business when compared with prior or future periods. A weighted average of the historical or future financial results, weighting less those periods impacted by the pandemic, may be necessary.

Must use: Projections
When utilizing financial projections for a discounted cash flow analysis, your valuation professional should use care in reviewing the projections and communicating with management to ensure that the assumptions used in the projections reflect the anticipated results of your business in the current economic climate. Finally, items like decreased revenue due to customer attrition, increased raw materials costs in cost of goods sold and fluctuations in operating expenses must be carefully reviewed prior to using financial projections in a valuation analysis.

Must be wary: Transaction Multiples
Given the changes in the economy, your valuation specialist should be very wary of using transaction multiples from 2020 through the guideline company transactions method. If this valuation methodology is employed in a valuation analysis, a detailed review of the specific factors making up the transaction multiple must be performed, specifically the inclusion and amount of any earn-out payments.

Article contributed by Randall C. Raifsnider, ABV, ASA, a Partner in Herbein’s Management Advisory Services group.