Thursday, 26 March 2020 By John Dawson Introduction As we have seen, the worsening COVID-19 situation is having a dramatic impact on world equity markets, with listed equity values worldwide in a downward spiral not dissimilar to the declines last seen in 2008/2009 at the time of the Global Financial Crisis. Governments around the world are attempting to halt the decline by a combination of: a) Monetary policy - reducing interest rates and buying of Government bonds b) Fiscal policy - issuing spending ‘packages’ to stimulate economies in local geographies. However, thus far these measures are having a limited impact. The decline in traded equity values on world markets is largely the result of two factors: a) A decrease in the future cash flow expectations for assets. Listed companies in affected industries and the sophisticated investors that follow them (professional and institutional investors and brokers) have made downward adjustments to their forecasts to reflect the expected reduced demand for products and services b) A re-pricing of risk, which in turn reflects the uncertainty of the likely size and timing of the impact of COVID-19. Yields on Government bonds have also declined, with the yields on 10-year USD bonds and AUD bonds currently 0.8% and 1% per annum respectively. These nominal yields imply negative real yields on 10-year Government bonds in the range of 1% to 2.0% per annum in both the US and Australia (assuming a long term inflation rate in the range of up to 2.5% per annum), a phenomenon which historically has rarely been seen in world markets. This reflects a ‘flight to quality’ with investors accepting a significantly lower return as compensation for the greater security offered by Government bonds. Implications for valuations Values of businesses have changed as a result of COVID-19 and the recent significant decline in equity values poses real difficulties for the valuation of businesses, shares and other equities in the current economic environment. The difficulty centres around the uncertainty of the likely future impact of COVID-19 on the earnings and cash flow generation capability of businesses, and the timing of any recovery from the impact of COVID-19 on businesses. These difficulties are reflected in the fact that: a) the equity markets continue to be volatile b) a number of planned public capital raisings and IPOs have either been deferred or are in the process of being deferred c) due diligence activity on some planned acquisitions has been put on hold by acquiring parties. Generally speaking, there are a limited number of levers which can be ‘pulled’ when re-pricing valuations of businesses: a) An adjustment to the projected future cash flows or earnings of the business b) An adjustment to the discount rate used to discount the projected future cash flows at (a) above c) An adjustment to the multiple used to capitalise the earnings at (a) above d) A combination of the above. Adjustments to future cash flows and earnings Listed companies in affected industries and the sophisticated investors that follow them are able to make adjustments to the key assumptions underpinning their forward-looking cash flow models and assess the value impact of those adjustments. It is unlikely that the future cash flows of any business will be unaffected by the current crisis. They will therefore likely require some adjustment. Where the cash flow outcomes are uncertain, best practice would dictate that various scenarios of cash flow outcomes are modelled and probability weightings applied to those cash flow outcomes (‘expected cash flows’). This will ensure that valuation outcomes are not dependent on assumptions which underpin any particular fixed forecast set of cash flows. However, detailed cash flow forecasts are not prepared for many privately owned businesses for periods beyond their immediate budget year. Consequently, the value impact of likely reductions in the future cash generation of will not have been assessed, at least initially. In valuing privately owned businesses, in the absence of detailed forecast cash flows, reference could be made to the historical and near term earnings of the subject business, which are then capitalised by an appropriate price-earnings multiple (‘the Market approach’). In the current environment, however, reference to historical results for valuation purposes will likely result in overvaluation, as it is now almost certain that historical earnings will not be an appropriate indicator of the likely future earnings of businesses, particularly in the short to medium term future. Instead, significant reliance is now likely to be placed on budgets for businesses where those budgets are adjusted for the impact of COVID-19. Care must be taken with this approach, however, because it assumes that the medium to long term earnings will be similar to those in the budget year, an assumption which is unlikely to hold and may result in under-valuation if the business is in an industry which could quickly recover from the economic impact of COVID-19. There are also problems with identifying the appropriate multiple to apply when using the Market approach. Absent the current problems, reference would typically be made to the multiples implicit in historical transactions involving similar businesses in similar industries (‘transaction multiples’), but those transactions took place in a pre-COVID-19 environment and would be expected in most cases to be higher than those implicit in present day valuations. One possible way to adjust those multiples is to analyse the percentage decline in the earnings multiples implied by the current market capitalisation of a listed peer group of companies operating in the same or similar industry and applying that decrease to the previously observed transaction multiples. This is a somewhat crude measure, but it will be some time before robust transaction multiples become available in the post COVID-19 era. Adjustments to discount rates Under the Income approach to valuation (such as the discounted cash flow method), the value of a business is assessed as being equal to the present value of its expected future cash flows. In determining the present value, those future cash flows are discounted using an appropriate risk-adjusted discount rate which is typically calculated using the capital asset pricing model (‘CAPM’). Arithmetically, the use of the (currently declining) yields on long-dated Government bonds as a proxy for the risk-free rate in assessing an appropriate cost of equity under the CAPM framework would (leaving all other components unchanged) imply a reduction in the cost of capital and hence discount rates. This assumption needs to be carefully examined in the current market. Intuitively, it is difficult to accept the proposition that investing in assets and equities is less risky now than in the period leading up to the emergence of the impact of COVID-19. In fact, the current volatility in world equity markets would indicate that the risk of investing has increased, not decreased. It is also true that the cost of capital is a long-term measure and is generally applied to long term cash flows, so it is arguable whether any adjustment to discount rates should be made to reflect the impact of COVID-19. (This latter position depends on the view taken as to the likely period of impact of COVID-19 and whether that period can be readily identified.) Bearing the above matters in mind, in undertaking valuations of businesses in the current market, careful consideration should be given as to how (if at all) the inputs into CAPM, including the risk-free rate and equity market risk premium, should be adjusted in assessing discount rates. Some valuers are now proposing that, rather than adjusting expectations of future cash flows (or where it is not practical to do so), an ‘alpha factor’ (i.e. a COVID-19 risk premium) be included in the discount rate to reflect the increased cost of equity finance. It is relatively easy to raise questions in relation to this approach, including the following: a) How should the ‘alpha factor’ best be quantified? b) Over what period should the ‘alpha factor’ be included in discount rates? c) What adjustment (if any) is required to estimates of the risk-free rate and market risk premium when an ‘alpha factor’ is included in discount rates? d) How can the value outcome under such an approach be reconciled with value outcomes under alternative approaches? Valuations at historic dates Valuers are often asked to value businesses at historic dates for taxation and other purposes. It is worth re-emphasising that, if the appropriate measure of value is ‘fair market value’, the impact of COVID-19 should not be factored into valuations conducted at dates prior to the impact of COVID-19 becoming known (that is, they should not be conducted with the benefit of hindsight). Conclusion There is no doubt that COVID-19 does and will continue to pose significant problems for the valuation of assets, businesses and equities in the short to medium term. The traditional approaches to valuation need to be carefully re-considered in the current environment. Valuers will need to determine whether the quality of financial information available to them is fit for purpose and what adjustments, if any, should be made to earnings and cash flow forecasts, earnings multiples or discount rates. Those issues must be resolved on a case-by-case basis – there is unlikely to be a ‘catch all’ approach which can be applied across businesses in all industries.