Company valuations are typically based on income, market, and cost (or asset) approaches, all of which have pros and cons. Because the COVID-19 pandemic has had such significant impacts on many businesses and our way of life, valuation professionals are putting more emphasis on the discounted cash flow (DCF) method, which is a variation of the income approach. DCF analysis calls for a great deal of discernment on the part of the valuation specialist, coupled with ownership’s views on the company’s long-term prospects. There are also several other factors that business owners should consider this year.
Each business is different.
The pandemic has not impacted every business in the same way, so valuations should be viewed differently. Risks and uncertainties for many companies are elevated, which affects business valuations. The financial conditions and operational outlook of a company are going to vary based on the nature of the business and to what extent it has suffered or benefited from the crisis, or both.
Economic recovery is still uncertain.
How much the economic recession and recovery affect expectations for growth and profitability are still fairly unknown. It is difficult to forecast precisely when life may return to normal, although we are getting closer with greater availability of the vaccine.
Weighted Average Cost of Capital (WACC) has been trending higher.
The WACC is a calculation of a company’s cost of capital under which each category of capital is weighted proportionately. Many underlying market-derived WACC inputs have increased recently due to the risks and uncertainties imposed by the pandemic.
Risk must align with the business’s projections.
The discount rate should be developed in correspondence to the forecasted risk fully assessed to account for the effects of the pandemic on the cash flow of the business.
Pre-COVID market transactions carry little weight.
Under the Guideline Transaction Company Method (GTCM), valuation indications are seen as less reliable because the market multiples are dated, lack detail, and reflect price levels and earnings and outlook factors prior to the pandemic.
Online presence is more important than ever.
A company’s digital presence is critical in an era where everyone has turned to online access for nearly everything. The success of the online side of a business correlates to greater value in the marketplace, depending on the type of business. And with the Internet comes matters of cybersecurity, which can also affect the valuation of a company.
The cost approach has become more significant.
This is a time when many businesses have become financially distressed, so the cost approach valuation is often applied, especially in cases in which a company may be worth more based on the value of its net asset value.
Higher discount rates for lack of marketability.
In the COVID era, transactions have decreased. A drop in market activity tends to decrease liquidity.
The new normal.
Many companies have been forced to undergo structural changes to their operating models because of the pandemic, resulting in financial instability. This may lead to asset impairment charges of a significant extent. Ultimately, the pandemic has changed life for us all, and while the recovery continues, we will eventually return to a new state of normalcy, with some companies changed forever as a result.