- Revisions to projections: In relation to cash flow projections or maintainable earnings, we recommend thorough discussions and challenge with the providers of projections on whether and how, the implications of the events above are fully reflected in management’s expectations (e.g. changes in revenue, growth rates, margins, capital expenditures, etc.). Given the significant changes in the financial markets throughout 2020, and in expectations of business performance, the date at which the projections were prepared should be considered as well as other external factors including foreign exchange rates.
- Projections should, where possible, be compared to market evidence and will need to reflect a much higher probability of a weak economy in the short to medium term. In the case of discounted cash flow (DCF) analysis, if the projections cannot be updated, an ‘alpha’ factor may need to be applied to the discount rate which will clearly require consultation and judgment to reflect company and industry specific factors.
- Note that discount rate adjustments to correct for overstated cash flows are not best-practice as, without additional analysis, the concluded alpha may under- or overstate the correction. Under limited circumstances where alpha may be unavoidable, e.g. cash flows cannot be rigorously adjusted in a timely manner, practitioners should conduct additional analysis to consider and assess the reasonableness of the cash flow impacts implied by the risk premium (i.e. backsolve to the implied forecast and discuss with management).
- ‘Alpha’ adjustments should not be confused with illiquidity adjustments to discount rates, which are covered under separate headings to the right. Alpha is a specific risk premium because the set of cash flow projections being used may not be ‘expected’ cash flows. There may be some ‘downside’ scenarios missing from the ‘probability weighted average’ set of projections.
- Scenarios for projections: Different cash flow scenarios could be a useful way of understanding the range of potential outcomes for a business and its attached risks. For example, a business as usual scenario, a scenario with short/medium term disruption and a scenario with a broader and longer economic downturn.
- Long term growth rates: Long term growth rate assumptions should reflect market participants’ long term estimates for inflation and real economic growth, adjusted to reflect the outlook for the sector that a company is operating in as well as company specific factors. Typically the effects of new industries and technologies and the impact of competition within industries may limit company specific long term growth rates to a lower level than for the economy as a whole to at least some degree. However, the long term sector and company specific outlook may well have changed as a result of Covid-19, with some sectors demonstrating stronger growth and more resilience and others being relatively weaker than previously expected. The overall drop in risk-free rates, and indeed discount rates more broadly, is also arguably consistent with a reduction in long term economy wide nominal growth expectations to at least some degree, due to changing expectations of inflation and/or real economic growth. It is therefore important that the discount rate and long term growth rate assumptions used within a valuation are internally consistent, otherwise the capitalisation rates / multiples implied within terminal values may not be realistic or reconcilable with market data.
- Discrete projection periods: Given the significant impact of terminal value calculations on overall DCF valuations, valuers may need to extend the discrete project period or perform some level of sanity checks on the terminal value (for instance by considering the multiple implied by the terminal value).
Balance sheet items
- Deferred revenue: It is not just earnings and cash flows that require discussion/challenge. For businesses in the travel sector, or where there are large amounts of deferred revenue, it may be the case that with bookings/income dropping off, there will be working capital shortfalls that need to be filled. This will clearly impact the valuation.
- Liabilities: It is also important to check that businesses are operating at their normal working capital level, as any surplus / deficits will need to be factored into the valuation. Any other excessive liabilities such as rent and tax deferrals should also be captured in the valuation.
- Real estate assets: 2020 was really a game of two halves from a valuation perspective. The first half saw the introduction of material uncertainty clauses across all sectors and assets (following guidance provided by the UK’s Royal Institute of Chartered Surveyors), reflecting the impact of Covid-19 and the challenges that this created. The second half of the 2020 then saw the gradual removal of such clauses in valuations on a sector by sector basis, which has helped to restore confidence in valuations. At present, these type of clauses remain only for certain operating assets (for example hotel and hospitality assets) or in exceptional cases at an individual asset level, at the discretion of the valuer. Moving forward, we expect the increased level of transactions in the market to help provide more market pricing reference points. Care will need to be taken in understanding the circumstances around specific transactions (e.g. to consider the potential impact of market distortions due to distressed sellers). So, in summary, for real estate assets we are proceeding with caution and paying a high level of attention to detail at an asset level.
Going concern versus gone concern
When scoping the valuation of a business with high levels of debt and/or limited debt servicing headroom, valuers will need to consider whether we can base our valuation on a going concern basis. Other metrics to consider are profitability, cash burn rate and covenant compliance. It may be more appropriate to assume that the business (or some segments within it) need to be valued on the basis of being put into run-off i.e. on a gone concern basis.
Fair value requires us to assume an orderly transaction (i.e. an appropriate period and amount of marketing in advance of the transaction). If the valuation is not for financial reporting then valuers will need to be mindful of the real risk of a business having short term liquidity crunches, which would mean needing to consider a distressed rather than an orderly transaction.
As these distressed transactions occur, the financial metrics arising from them will need to be treated with caution for the purposes of cross-checking to financial reporting valuations going forward.
And even if the valuation is indeed for financial reporting, if the business being valued is in distress, valuers will still need to assume an orderly sales process but might need to factor in larger illiquidity adjustments to ensure that the valuation is grounded in commercial reality.
Illiquidity adjustments to discount rates
In the immediate aftermath of Covid-19, we suggested that illiquidity adjustments might be required to discount rates for assets in sectors where we were observing that the marketplace had frozen up or its efficiency had diminished to some degree. We were careful to clarify that this adjustment was not the same as the ‘alpha’ adjustment as while alpha and illiquidity adjustments are related, they are not the same thing. By contrast, the UK is now experiencing a Deals led recovery, which would suggest that for many sectors, due to the availability of capital and demand for good assets. We are seeing an open and strong transaction market across most sectors. This means that illiquidity adjustments, to reflect a drop in M&A transactions, are unlikely to be relevant now in most cases. However, in certain sectors such as aviation, oil & gas, and the hospitality industry, we are still seeing distressed deals, where illiquidity may remain a relevant factor. Of course, standard illiquidity adjustments may remain appropriate depending on the nature of the asset being sold.
Cost of capital
At the current time, we believe that the Capital Asset Pricing Model (CAPM) and other established methods for calculating the cost of capital should continue to be used. As these approaches rest upon a theoretical basis which should hold in general – including in times of an economic downturn – there is no reason to adjust the general approach for calculating the cost of capital. However, a review of each input factor seems appropriate and assessment of the overall result is certainly required. For instance, the use of a normalised or smoothed risk-free rate may be advisable if a particular daily spot risk-free rate appears out of line with other days as a result of market volatility. Given the overall decline in risk-free rates and stock markets at the start of the pandemic, even if a spot risk-free rate was being used, it may have been necessary to consider an increase in the equity market risk premium from previous levels. However, equity markets have since staged significant recoveries with a number of global indices at or even exceeding pre-pandemic levels. This suggests that broader market discount rate inputs may actually be indicating lower discount rates than those seen prior to the start of the pandemic.
There has been significant differentiation in how sectors have performed and this should be considered when carrying out valuations. This is likely to be primarily through ensuring appropriate adjustments to forecast cash flows, but it is also necessary to consider any potential impacts on the specific discount rate inputs for individual sectors (i.e. the beta). Whilst lower discounts rates supporting higher valuations in some sectors that have been resilient to Covid-19 may be appropriate, in other more impacted sectors, discount rates may need to be higher to reflect the increased uncertainty and volatility that is present.
Applying increased scrutiny to previously assessed betas is appropriate to ensure that expected sector volatility is appropriately incorporated within the discount rate. Due to the extreme volatility experienced in March 2020 (and to a lesser extent February and April), there can be a disproportionately large impact from the data in these months on the beta calculations, in some cases causing betas to double or halve from previous levels. It may be appropriate to exclude the data from these particularly volatile months in certain circumstances to ensure the beta isn’t disproportionately weighted towards data from this highly volatile period. Whilst changes in beta may well be justified given the shifting patterns in sector performance, these changes should also be grounded in general expectations for the expected performance and relative volatility in the sector going forward, rather than just mechanically applied from historical data.
Cost of debt/gearing
Other components of the cost of capital may need to be adjusted to take into account industry, geographic or company specific risks arising out of current market conditions. Therefore, valuers must consider (on a case-by-case basis) whether the actual, current debt margins should be applied (or not) in order to estimate an appropriate cost of debt (e.g. depending on whether a company is funded short-term or long-term, the necessity of future (re)financing, promised vs. expected yield, assumption whether observed spreads persist indefinitely, etc.). The same principle holds for the appropriate target debt/equity ratio which, in general, we might expect to be lower relative to equivalent historical ratios in certain sectors due to the constraints on current debt financing packages.
Use of spot share prices for trading multiples
Additional care must be applied when relying on observable recent market transactions (if any) to benchmark DCF valuation analyses. If we observe heightened short-term volatility in share prices, it may be appropriate to use average trading multiples over several weeks instead of daily multiples and to review analyst forecasts (as an additional source of benchmark data). However, market prices should still be used as a plausibility check for our valuation results as there is a clear need to take into account all market evidence.
Public market volatility
Given the increased uncertainty, valuers might expect valuations to:
- Have more volatility associated with them. It is important to flag this to the users of valuations up front, particularly if those users are planning to rely upon them from a commercial perspective or where the valuation exercise is a recurring one;
- Have wider ranges, more scenarios and/or sensitivity analyses; we have provided further valuation guidance on the key uses of scenario analysis;
- Have point estimates within those wider ranges that are based more on judgement than underlying financial metrics in these times of heightened uncertainty; and
- Be accompanied by higher levels of disclosure in the case of financial reporting valuations. Those disclosures may wish to explain to the user that valuations could potentially change quickly over short periods of time (particularly where the subject business is highly leveraged).