Covid 19 – Valuation in an uncertain environment
The Covid-19 pandemic has created a simultaneous global health and economic crisis which has plagued financial markets. Share markets declined upwards of 30% globally, credit spreads have widened significantly and volatility has more than doubled over the same period. Whilst some parallels can be drawn to the global financial crisis, the speed at which economies and markets have been impacted and the extent of the global effect are unprecedented.
During these uniquely challenging times, we encourage our clients and partners to focus on the wellbeing of themselves, their families and their employees as a priority.
Despite the current uncertainty, boards, CFOs and others will need to make decisions around value to assess potential transactions, make capital allocation decisions and to comply with financial reporting, unit pricing and taxation obligations. We have therefore provided some brief guidance on the factors that require additional reflection when conducting valuations in the current environment.
There are a number of inter-related factors that need to be considered:
- Cash flows / earnings: Future cash flows for virtually all companies will be impacted in some way in at least the short-term whereas some companies will have longer term effects.
- Repricing of risk: In times of economic uncertainty, investors often re-allocate funds to cash or other low-risk asset classes to protect capital. Consequently, prices for riskier assets such as equities and corporate debt instruments are then required to offer higher returns (or risk premiums) to induce investors. The situation this time is no different. The cost of equity and debt has increased for most market participants. For example, our assessed equity market risk premium (“EMRP”) has increased by approximately 100 bps since 31 December 2019.
- Divergence between price and value: Fear and momentum often dominate fundamentals in uncertain times. This will likely result in opportunities to acquire distressed, illiquid or out-of-favour assets at prices below their intrinsic value.
- Some valuation methods and inputs may be less reliable: Historical inputs based on data prior to the pandemic are unlikely to be reliable. For example, earnings forecasts or capitalisation multiples prior to the crisis will not reflect current market participant assessments of company growth prospects and risk. Applying the capitalisation of earnings method is therefore particularly problematic at the moment.
As a result of the above factors, the rigour required around the valuation process has increased, particularly in determining discount rates and projected earnings and cash flows. This leads to greater subjectivity and more divergence in opinions of value amongst market participants and practitioners.
We discuss each of these factors individually below.
1. Future cash flows / earnings
The response to containing the pandemic or ‘flattening the curve’ globally has generally involved travel bans, closing borders, restrictions on crowds, social distancing and enforced closures of non-essential services and businesses. These measures have had necessary consequential impacts on consumer demand, supply chains and economic growth in at least the near-term. A global recession seems to be an almost forgone conclusion at this stage but the financial impacts on companies are wide ranging and will vary significantly across sectors and for individual companies within each sector depending on the timing and path of the eventual economic recovery and the sensitivity/elasticity of individual companies to the economic environment as well as their competitive position and access to capital.
Key considerations for cash flow projections include:
- Economic impact: We don’t pretend to have a crystal ball but as valuers it is important to understand what the potential outcomes may be (in terms of depth of the likely recession/depression and shape and timeline of recovery). The trajectory and timing of the eventual recovery is a very important determinant to value. Will there be a sharp economic recovery assuming a return to some form of normal in the near-term (i.e. a “V” shaped recovery), a prolonged recession (a “U” shaped recovery) or some other trajectory (the Nike ‘swoosh is another profile making its way around the pundits). The assumed recovery trajectory could be a difference in the timing of the recovery of up to 2 years (McKinsey’s worst-case scenario envisages the world economy returning to pre-crisis growth in Q3 2022). The reality is that there is no objective ‘correct’ scenario but it is necessary to take a pragmatic view and consider at least a best case and worst case economic scenario to assess the ‘goalposts’ in the analysis of the projected cash flows.
- Industry impact: The impact of the economic outlook, and potential change in consumer behaviour for some sectors will vary. For example some sectors may only be exposed to short-term fluctuations from enforced shut-downs (such as hospitality, energy, super-markets, etc) whereas other sectors may be exposed to a prolonged slowdown due to change in consumer behaviour and demand over the long-term as well. However, some companies or industries are likely to be benefactors in the long-term, for example due to potential increase in demand for logistics, healthcare, data infrastructure, etc.
- Company specific factors: Ultimately the ability of each company within a sector to weather the economic storm and participate in the eventual recovery will depend on company specific circumstances such as competitive position, supply chain, access to capital (including access to government stimulus) and ability to access labour and other resources when required.
Estimating future earnings / cash flows in light of this is extremely difficult and subjective which is why a number of listed companies have withdrawn earnings estimates and many sell-side analysts have yet to update their earnings projections. Whilst the above factors could arguably be reflected through inclusion of an additional risk premium or alpha in the discount rate, in our view, given the current environment this approach is nothing more than a ‘finger in the air’ as detailed consideration of the earnings/cash flow impact should be quantified in order to estimate an appropriate adjustment to the discount rate. We consider it is significantly more reliable to adjust the earnings or cash flow projections explicitly wherever practical.
2. Repricing of risk
In times of financial market uncertainty and volatility, investors often re-allocate a greater proportion of their investments to cash or other low-risk asset classes in order to preserve capital. Riskier assets such as equities and debt instruments are then required to offer higher returns (or risk premiums) to induce investment. The current environment is no different as evidenced by increasing risk premiums for risk assets. For example:
- Equities: Along with changes to expected cash flows, valuations are also impacted by increased risk aversion and greater uncertainty regarding future cash flows. This has led our assessed EMRP to increase from 6.75% in December 2019 to a range from 7.5% to 8.0% at 31 March 2020 as set out below:
In some limited cases where there is a particularly high level of uncertainty arising from the Covid-19 pandemic resulting in there being no reasonable basis to estimate appropriate scenarios for the business and its cash flows, an additional alpha factor may be required. However, as mentioned above, selecting this additional risk premium is highly subjective.
- Cost of debt: Similar to equities, yields for debt instruments have increased sharply since the onset of the crises, particularly for non-investment grade credits which are higher risk. For example, as set out below, the yield to maturity for investment grade (“IG”) bonds and non-investment grade (“Non-IG”) bonds have increased. In addition, the spread between IG and Non-IG has also widened reflecting a repricing of risk by fixed income investors as set out below:
- Sovereign debt: In an attempt to mitigate the longer-term economic impact of Covid-19, most nations have taken wide-ranging fiscal measures to protect businesses and provide an expanded social welfare net to hopefully allow for a quicker recovery trajectory. The expected global cost of this is already expected to exceed $7 trillion. The funding of these policies will likely create fiscal deficits for the foreseeable future in most regions.
This has impacted sovereign credit profile for a number of countries including Australia. During March 2020, as the federal government announced over $300 billion in stimulus packages, the yield to maturity on Australian Government 10 year bonds (the most common risk-free benchmark used in Australia) increased from 0.60% on 9 March to 0.79% by 31 March 2020, indicating a reassessment of the credit risk of sovereign bonds.
3. Divergence between price and value
Uncertainty tends to spook capital markets which can result in momentum being the main driver of returns/prices rather than company fundamentals. This is part of the driver of the rapid decline in global share markets during the pandemic as new information on cases, etc comes to light. However, the momentum of markets can work both ways. For example the share price of Chinese company Zoom Technologies increased over 300% on the NASDAQ in March 2020 as some investors confused the company for Zoom Video Communication (the video conferencing application that has seen a surge in demand during the pandemic). The fact that Zoom Technologies proclaims to have ‘no significant operations’ and has not filed any financial statements since 2015 didn’t seem to deter many investors!
In periods of extreme volatility such as we are experiencing at the moment, there can be greater divergence between ‘price’ and ‘value’ due to:
- Information asymmetry: The real time nature of this crises means that the financial impacts can change on an almost daily basis for some companies. As a result, there may not be equal access to material information (such as sales data, revised business plans, access to stimulus measures, etc.) amongst market participants (between a buyer or seller for instance).
- Short-term focus and momentum: In periods of uncertainty and heightened volatility, investors often put more weight on short-term factors and/or momentum and may not be placing adequate emphasis on the longer-term prospects of companies.
The divergence between price and value coupled with a number of companies requiring capital to repair balance sheets or shore up their capital position is likely to result in opportunistic offers for distressed, illiquid or out-of-favour assets. Due to significant fundraising in recent years by private equity, infrastructure and other funds, there is significant uninvested capital, or dry powder, that can be deployed. For example, the global private equity sector had $1.5 trillion in dry powder as at 31 December 2019 according to Preqin.
4. Reliability of different methodologies
The rapid change in the economic outlook and in the varying impact on the prospects for individual industries and companies means that, more so than ever, past results are not an accurate predictor for future outcomes.
Relying on historical valuation or pricing benchmarks such as earnings or revenue multiples predicated on financials or transactions that do not reflect the earnings and growth impacts of the pandemic are unlikely to be representative of current market participants’ views on growth and risk.
Furthermore, forward earnings multiples observed from the share trading of listed companies need to be investigated to understand whether earnings estimates have been updated post Covid-19 since a number of companies and sell-side research analysts have either not updated their earnings estimates or withdrawn them due to the significant uncertainty in forecasting in the current environment. As a result, forward earnings may not be representative of expected outcomes or market participant assumptions.
Whilst market methods such as share trading and capitalisation of earnings should not be entirely ignored in the current environment, it is important to ensure adequate understanding of the assumptions in respect of required returns, growth, risk, etc implicit in these metrics. Therefore. we would recommend undertaking discounted cash flow analysis as a primary approach with consideration of available market metrics (such as earnings multiples) as a secondary approach or cross-check, wherever practical.
5. What does this mean for you?
Despite the current uncertainty, boards, CFOs and others will need to make decisions around value to assess potential transactions, make capital allocation decisions, comply with financial reporting, unit pricing and taxation obligations.
The above factors will pose some issues that boards and CFOs need to consider in the current environment. For example:
- Opportunistic transactions: the volatility in market pricing due to short-term momentum and sentiment, rather than fundamental value drivers, may result in opportunities for buyers to make accretive acquisitions at potentially discounted prices or require target companies to assess whether an offer received is opportunistic or ‘fair’ given the current economic environment. Ensuring adequate diligence on the pricing of any transaction is even more critical in the current environment.
- Financial reporting and impairment: Given the combination of higher discount rates, lower cash flows (in at least the near-term for most companies) and longer-term uncertainty in some industries, it is likely that impairment testing will be high on the radar for boards and auditors in the lead up to the 30 June reporting period (or sooner if an impairment testing trigger for finite life assets has occurred). The level of rigour around cash flow forecasts (e.g. consideration of scenarios) and discount rates required to form a reliable conclusion will therefore have increased from previous periods.
- Valuation frequency: Valuations undertaken prior to the pandemic are not likely to be a reasonable proxy for the current value due to the substantial change in discount rates and earnings/cash flows for most companies. Companies with fair value requirements (for unit pricing, financial reporting or otherwise) may require valuations more frequently now given the pace of change in the global economy and financial markets at the moment. This is already evident with many of the large superfunds (such as Australia Super, IFM and HostPlus) announcing out of cycle re-valuations for their unlisted infrastructure, private equity and property assets.
- Capital allocation: Companies in the enviable position of having capital available to deploy in their business at the moment need to be particularly mindful of how this is deployed. In particular, understanding the long-term growth and return expectations across potential investments (including the buyback of company shares if they are perceived by the board to be under-valued) is critical. This assessment becomes more critical when investment alternatives exist across industry sectors, the existing supply chain and/or geographies where economic prospects and risk profiles may vary.
- Capital raising and dilution: As was experienced during the GFC, early indications are that a number of companies will seek to raise capital to either repair balance sheets or to provide a buffer/downside protection for a protracted economic slowdown. Any dilutive impact of expected near-term capital raisings should be considered in the context of current valuation. Directors also need to ensure that any significant capital raisings that impact on shareholder control of the company are reflective of arm’s length terms and fair market value in accordance with the Corporations Act and other regulatory requirements.
We’ve collated the following resources to assist you in undertaking your impairment testing analysis:
- Market Risk Premium analysis as at 31 March 2020
- Technical Guidance to Valuations during COVID-19
- Impairment fundamentals
If you have questions about your specific situation, feel free to contact us for an obligation free discussion.