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Valuations in times of market uncertainty

UK Valuations practice guidance

January 2021

The scope of this guidance

This guidance provides recommendations for valuation considerations, which will be particularly relevant for impairment exercises and the fair value of unquoted investments, as valuers consider the 31 December reporting date and beyond.

These valuations will be particularly judgmental as they are performed against the backdrop of public market volatility and concerns regarding the impact of both Covid-19, including from expected monetary and fiscal policy changes in key territories, and oil and other commodity price movements. Indeed we will be reflecting on the impact of the UK's budget announcement in a subsequent article.

Fair value for financial reporting purposes is an exit price concept and therefore inputs need to be based on current market participant assumptions and views.

While valuation will certainly be more tricky and judgmental in the coming period, we are sharing this guidance to emphasise that it remains possible to arrive at a view on value, albeit one with a wider range. The methodologies that we have always applied will likely remain appropriate; what will need to be revised is the information that is flowing into the valuation and how we adjust market inputs if we feel that there is an element of ‘noise’ or excessive volatility.

This UK guidance is primarily focused on the valuation of illiquid assets and was initially drafted as a response to the turbulence experienced in public markets in 2020 due to Covid-19.

Since the beginning of 2020, we have observed significant volatility in global public equities (increases as well as falls in share prices). In fact, the level of volatility in equity markets around the world in the early stages of the Covid-19 pandemic surpassed levels experienced at the start of the global financial crisis.

Whilst volatility has fallen back from these extremes, it remains elevated relative to pre-pandemic levels, meaning that valuations will remain tricky and judgmental in the coming period (as they were during much of 2020).

We are sharing this guidance to emphasise that it remains possible to arrive at a view on value, albeit one with a wider range and to highlight the following key messages to help in dealing with the current uncertainty:

  • Price vs. Value – Whilst it is always important to remember the distinction between the two, it is even more critical in the current market to ensure that it is possible to separate fundamental value changes from potential ‘noise’ in the pricing of public securities.
  • Recognise the volatility – we advise against ignoring periods of increased volatility. While heightened volatility reflects increased uncertainty and makes valuations more challenging, in our view, it is still possible to perform robust valuations that reflect market conditions at the valuation date.
  • What’s the story underpinning the valuation – Valuations begin with numbers but closing a valuation requires telling a story that fits together. Valuations can make little sense when bringing together various pieces of data without stepping back to consider if they work in unison. This is a particular risk in the current environment given there have been significant movements in several fundamental valuation inputs.

This guidance provides recommendations for valuation considerations, which will be particularly relevant for impairment exercises and the fair value of unquoted investments. The methodologies that we have always applied will likely remain appropriate; what will need to be revised is the information that is flowing into the valuation and how we adjust market inputs if we feel that there is an element of ‘noise’ or excessive volatility.

CBOE* Market Volatility Index (^VXO) - Index Value
CBOE* Market Volatility Index (^VXO) - Index Value

* CBOE Global Markets, Inc
Source: CapitalIQ as at close of 31 December 2020

Movements in equity indices since 1 January 2020

In March 2020, global stock markets turned ‘bearish’ with a decline in major equity indices around the globe. At their trough, the highest declines in indices ranged between 28% and 42% (Nikkei and FTSE 250 respectively) from their respective 2020 openings.

The S&P 500 and Nikkei 225 indices have since returned to and exceeded their January 2020 levels, whilst the FTSE 250 now only trails its January 2020 level by approximately 6%.

Although the initial declines in share prices were severe and the most rapid since the global financial crisis, with hindsight this may now be viewed as a phase where pricing ‘noise’ dominated value fundamentals. The degree of uncertainty was substantial as investors grappled with an unfamiliar event and struggled to assess its impact on businesses. This led to share prices fluctuating significantly on a day to day basis (and even within a single trading day).

However, stock markets regained a meaningful portion of the decline fairly rapidly which was then followed by a more gradual (albeit still volatile) recovery to levels close to or even exceeding pre-pandemic levels. Whilst volatility still remains above pre-pandemic levels, the recovery in share prices is indicating that investors have become more accepting of the uncertainty that persists and pricing noise is much lower than at the onset of the pandemic. This is the context in which valuations need to be performed in the current environment.

Market indices are also heavily influenced by their sector weightings, with the S&P 500 weighted towards technology (28%) and healthcare (13%); two sectors which have proved to be more resilient to the effects of the pandemic and therefore contribute to the rise in the index.

The increase in share price over the last quarter also reflects the optimism surrounding the approval and roll-out of the Covid-19 vaccine (a shot in the arm for capital markets, especially for the aviation, oil & gas, and hospitality segments), with the reality of Brexit having a dampening effect.

The decline in equity prices since February 2020 was the most rapid and sharp decline since the global financial crisis. Since then, most indices have demonstrated a robust bounce back.

Movements in equities indices since January 2020

Movements in equity indices since 1 January 2020

Source: CapitalIQ as at close of 31 December 2020

What are markets now indicating regarding valuation fundamentals?

Debt margins on borrowing initially increased sharply but have since fallen back and generally ended the year at or below levels seen prior to the start of the pandemic. This essentially mirrors the initial nervousness that caused share prices to drop sharply before staging a recovery over the rest of 2020. However, whilst average market spreads on bonds at investment grade ratings have returned to pre-pandemic levels, in sectors significantly impacted by Covid-19, companies may have experienced credit rating downgrades, which will likely result in them facing increased borrowing costs.

Risk-free rates fluctuated in March 2020 but ended the year around 0.5% to 0.75% lower across the UK, US and Europe relative to January 2020. 

Movements in UK, US and EUR risk-free rates since 1 January 2020

Movements in equities indices since January 2020

Source: CapitalIQ, PwC analysis as at close of 31 December 2020

The risk-free is a key input into all discounted cash flow (“DCF”) valuations and a lower rate would, all else being equal, indicate lower discount rates on a broad market basis than pre-pandemic.

Furthermore, the fact that both debt margins and share prices have largely returned to pre-pandemic levels (the latter despite generally lower forecast cash flows) is a further indicator of lower, rather than higher discount rates.

Lower discount rates may seem somewhat counterintuitive given the uncertainty that is present but it is likely to be at least part of the story required to rationalise the share price recovery. In a sense, investors have now come to terms with the uncertainty that is present, and we should do the same in our valuations.

However, this is only part of the story as the level of recovery in share prices shows substantial variation by sector.

In the early stages of the pandemic, all share prices experienced significant falls, perhaps as investors rushed to factor in the impact of the pandemic and made broad based judgements. As the crisis progressed and more information became available, the gap in share price sector performance began to widen and largely still persists.

Again, this provides further evidence of valuation fundamentals breaking through the pricing noise. Share prices in sectors more resilient to Covid-19 have performed more strongly, reflecting both the relatively stronger cash flows and the potentially less volatile outlook.

This highlights the importance of being able to tell the valuation story for each individual company. Whilst there will be cases where lower discount rates support higher valuations, this is not a blanket rule that should apply to all companies regardless of their situation. Clearly there will also be cases of companies where cash flows are much lower and uncertainty is currently very elevated; it is unlikely that lower discount rates will be appropriate in these instances.

The roll-out of the Covid-19 stimulus and recovery packages, have been, and continue to be, a contributory factor in maintaining low risk-free rates as highlighted in this blog.

UK high-yield corporate bond spread over UK Gilt curve

Source: CapitalIQ as at close of 31 December 2020

UK valuations team guidance on valuation in times of market uncertainty

Points of debate

  • Observable transactions or trading multiples generally serve as benchmarks in the fair value concept. Private equity backed transactions are an increasing percentage of all corporate transactions. Given the nature of certain deal structuring, the headline deal multiples can be distorted / misleading. Can valuers still use recent asset transactions (if there are any) or trading multiples taken from stock prices as appropriate benchmarks? Whilst it is tempting to focus on the impact of share price volatility on market multiples, the more pertinent question to ask may be whether projections have been appropriately adjusted for changes in earnings and balance sheet values as a result of issues with the supply chain and/or changes in the demand for products/services.
  • Companies with high levels of debt and/or limited debt servicing headroom (e.g. because they have low operating margins or low cash flow conversion, particularly where costs are fixed e.g. salaries, rent) have an increased likelihood of liquidity issues and this should be captured in valuations accordingly. Whilst debt margins have returned to pre-pandemic levels as investors returned to the market to invest in resilient companies, companies in more significantly impacted sectors may have experienced credit rating downgrades which will likely lead to increased borrowing costs
  • Share prices fell earlier in 2020, which clearly impacted multiples (as earnings estimates took some time to be adjusted downwards). However, now that earnings forecasts have generally been adjusted, the more prescient issue is how to ensure that any benchmark multiples are being applied to appropriately revised cash flows and reflecting any differences in expected recovery profiles.
  • Given the volatility in stock markets, do valuers need to make any adjustments to the way in which we usually calculate discount rates or to specific inputs such as the equity market risk premium?

Actions to take (for all types of valuations)

Click through the headings below to read more.

Projections

  • 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).

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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.

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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.

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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.

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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.

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Sector considerations

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.

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Beta

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.

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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.

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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.

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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).

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Key take-aways

In the current climate, financial reporting valuations need to consider not only the turbulence in public markets but also the impact on cash flows, growth rates and margins of recent developments related to Covid-19 and we reiterate the following three key messages.

 checklist red

1. Price vs Value

There was significant price volatility in markets during 2020. Valuers need to consider the purpose of the valuation and the context of the market at the relevant valuation date (amongst other factors) to determine how much of this pricing noise should be imported into the valuation.

 downtrend red

2. Recognise the volatility

Whilst mechanistically matching market share price changes in private company valuations may not be appropriate, at the same time arguing that the whole market is too volatile and therefore insulating the valuation from changes in the market will be equally inappropriate. Over the course of 2020, investors learnt to accept and price the increased volatility, and we need to do the same for valuations.

3. What’s the story

Despite the significant volatility in 2020, market data is now indicating that the broader discount rate inputs may actually be lower. However, any updated discount rates must be used with cash flows that have also been appropriate revised and consider whether a lower rate appropriately reflects the relative uncertainty for the specific sector. There needs to be a clear valuation story that brings together the changing cash flows, discount rates and uncertainty to ensure any valuation conclusions are reasonable.

Contact us

Kellie Gread

Kellie Gread

Valuations Leader, Consumer Markets, Industrial Products and Business Services Partner, PwC United Kingdom

Attul Karir

Attul Karir

Financial Services Partner, PwC United Kingdom

Tel: +44 (0)7931 735202

Charles Sword

Charles Sword

Tax Valuations, Deals, PwC United Kingdom

Tel: +44 (0)20 7212 3391

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