By Terrel J. Lavergne CPA/ABV, CVA
COVID–19 and the current economic downturn have changed the world and present new challenges and complexities to the valuation profession. Small to mid-size businesses, in particular, will be significantly affected. Some businesses will fail, and the downward trend of values is clear. So, with clouds everywhere, is there a silver lining?
Current valuation factors to consider include:
- Valuation date – What was known or knowable?
- Market approach – Relevance of multiples: From private company transactions prior to the crisis and based on public company trailing earnings
- Income approach – Risk, growth assumptions and uncertainty
- Asset approach – The reliability of underlying asset values, especially in the case of a real estate holding company
The fair market value standard compels us to consider only information that was “known or knowable” on the valuation date. With a December 31, 2019 valuation date, COVID–19 would be considered a subsequent event, with no effect on value. There is a general consensus among valuation professionals that the potential impact of COVID–19 became known or knowable on or about February 29, 2020, though some say the effects were not fully known until March 31, 2020. As to the seriousness of the pandemic, there has been much divergence of thought and deliberation about who knew what and when.
Given the substantial impact COVID–19 has had on the operations and outlook of businesses throughout the U.S. (and the world), it might be advisable for appraisers to include a discussion of the concept of “known or knowable” in every valuation report.
In private entity valuations, the market approach may be the most difficult to apply. The market approach values a business based upon multiples paid in recent transactions or market multiples observed from guideline companies that are publicly traded. For valuations after February 2020, market multiples based on pre-crisis transactions may not be relevant without some sort of subjective adjustment. Public company price-earnings ratios based upon historical earnings, likely fall in a similar category. Business appraisers might want to consider earnings projections rather than trailing measures in computing price-earnings ratios under the guideline company method.
As for the income approach, it is also safe to say that most projections prepared before March 2020 need to be revisited for current valuations. Especially in this current economic environment, historical revenues, expenses, and profit margins may not be the most reliable indications of future performance. While never easy, estimating future cash flows and the cost of capital (discount rates) have become more challenging, and we importantly note that the current data used to compute discount rates under the build-up method do not yet factor in the COVID–19 crisis. In general, though, we would expect that the company-specific risk would increase for many businesses.
Given the turmoil in the commercial, retail and residential sectors of the real estate industry, the values of real estate holding companies are also likely to be especially affected. Tenants of every shape and size are not paying rents or asking for forbearance, and our MAI friends are telling us that commercial real estate values are likely decreasing due to declining NOI and higher capitalization rates (they, too, suffer from a dearth of current “comps”).
Combining the market and cost approaches, one easily discernible trend has been the widening of the discounts from net asset value at which closed-end funds have been trading (as they did in the Great Recession). This greater gap can translate into larger discounts for lack of control applicable to securities holding companies. Market volatility, moreover, can increase the size of discounts for lack of marketability applicable to both holding and operating companies. Obviously, these developments, coupled with historically low interest rates, present estate planning opportunities for the savvy client and professional advisor.
In summary, valuations with effective dates after February 2020 have become more challenging to perform. Because of the increased risk and greater uncertainty, however, it is an opportune time for intrafamily transfers and other estate planning techniques.