Record Point is an independent corporate advisory firm with operations in Sydney and San Francisco. We specialise in domestic and cross-border advisory services for public and private companies including mergers and acquisitions, capital raisings, corporate partnerships, debt advisory, restructuring, strategic reviews and valuations.
Around this time last year, we released a thought piece on valuation titled “what is the right value?”. Since then, COVID-19 has had a material impact on the economies of the world with implications for the approach to company valuation. While the pandemic may not have changed the fundamental concepts of valuation, there are a range of factors to consider in relation to assessing the appropriate valuation in a COVID affected world.
Benchmarking analysis
Recap: What multiple of earnings would investors pay compared with known precedents in a market
References from precedent transactions are useful to inform company valuation to the extent businesses and their environments are comparable and there is sufficient data to reliably draw conclusions. Benchmarking against pre-COVID precedent transactions should be undertaken with caution while there is a mix of temporary and lasting impacts across global economies and markets that may result in historic valuation references disconnecting from the current environment.
As an illustrative example, if you were willing to pay 10x EV/EBITDA for a company in 2019, would you still have the appetite to pay the same multiple now if the EBITDA being multiplied is impacted by government stimulus, short term supply/demand disruption and lasting impacts on the company’s economic drivers? If your answer is yes, what would be the appropriate EBITDA profile to apply this multiple to (i.e. LTM, forward or a “maintainable” hybrid)?
While we continue to see precedent transactions as an important valuation data point, the current environment requires a more intuitive approach, taking into account the potential factors that may distort the referable earnings base and/or the appropriate capitalisation rate or multiple.
Recap: Used to assess relative value against publicly traded peers
Public market trading has been turbulent since COVID-19 hit global markets in March 2020, leading up to the announcement of a vaccine in November 2020. While turbulent trading is not uncommon in a normal year, the rate of volatility experienced during this period was particularly extraordinary (subject to sector exposure).
Consequently, drawing valuation perspectives from the public markets in 2020 has been challenging and at times, less predictive of ultimate company value than it would have been during pre-COVID periods. Moreover, there is ongoing uncertainty around post-COVID global economic recovery that may result in continued volatility for some time yet.
Erratic swings in valuation are more often observed in the public markets (compared to private) due to the liquid nature of small parcels of traded securities. Careful consideration should be given when using these data points to interpret valuation references for private or majority stake public transactions.
Intrinsic valuation analysis
Recap: Technical analysis to assess the embedded value of future cash flows (or assets), typically focused on discounted cash flow modelling
Global interest rates are currently at all-time lows and the combination of unprecedented fiscal stimulus has effectively created a zero-cost money environment. As interest rates and growth rates are key inputs into intrinsic valuation models, further consideration should be taken when applying current market data points to assess intrinsic valuation.
Interest rates
Global interest rates are at levels lower than historic norms and consequently, using the current 10-year government bond yield as a proxy for risk-free rate may understate the true cost of capital. Whilst there are arguments that this is the “new norm,” due consideration should be taken when applying these inputs to inform the cost of capital and value (particularly when valuing cashflows in perpetuity). Company boards and shareholders can often lag in their decision to adjust hurdle rates and target asset prices as familiarity typically has a strong influence in this decision-making process.
Growth rates
There is high conviction across many industries that businesses (and cashflows) will ultimately return to “normal”, however the key considerations here on valuation is 1) when and 2) at what levels. These considerations make it challenging to appropriately price in the risk of cashflow uncertainty (particularly into the cost of capital).
An investor may either apply an additional risk factor to the cost of capital (rebalancing WACC to a more traditional level), or undertake a more practical exercise by assessing the risk through cashflow scenario analysis to determine valuation outputs under various recovery outcomes. An example to address the above questions through the latter approach may include:
Given this approach may place reliance on forecasting unpredictable outcomes (e.g. the Melbourne’s extended lockdown), it is imperative to ensure that forecasts are continually updated to the extent that valuation outputs are reflective of the everchanging operating environment.
Capacity to pay analysis
Recap: Technical analysis to assess the value a buyer or set of buyers can afford to pay while preserving or enhancing their shareholder value
The considerations here are company and industry specific, as different sectors have experienced mixed responses to the pandemic and consequently their capital return requirements. While broad inferences can be made about certain industries in relation to the new environment for growth and risks (e.g. technology vs travel), the reality is that each company’s response to the pandemic is unique and so is their capacity to invest (in context to other uses of capital).
Strategic value assessment
Recap: Assessment of extra market and competitive factors for the relevant investor or buyer set, may incorporate views on synergy value (cost and revenue synergies can be discussed)
Consumers and businesses alike have evolved in response to the pandemic. Throughout 2020 consumers have changed their way living and consequently, businesses have adapted their strategic focus and the way in which they operate (e.g., consumer trends shifting to online).
Many businesses are now operating more efficiently (i.e. headcount reductions, forced technology adoption) and synergies that existed pre-COVID may now be harder to find. Consequently, boards and investment committees would be well advised to place more scrutiny on strategic premiums and increase their emphasis on the realisation of synergies as part of hurdle rate assessments.
Conclusion
Forming a view on value in this environment remains a technical, analytical and resource intensive task as the considerations required are bespoke to each company, situation and purpose. Compared with the pre-COVID world, there is an increased requirement to take a step back and think about the valuation inputs and outputs required to adjust for potential COVID distortion.
There is always a need to be prepared and perhaps now more than ever, as relying on familiar metrics from the past may not be conducive to the most appropriate or optimal decision for today. If you are wrestling with the topic of valuation please feel free to reach out to one of the Record Point team and we can help you navigate through the situation to find the right path forward.
December 10th, 2020