In the geo-political space, it is expected that major realignments in global politics will ensue as economies seek to rebuild their social systems, industries, wealth and influence. Equally, this will have a major impact on how countries shape their fiscal and tax policies. 

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All of the above have significant impact on how businesses are valued, the accuracy of future projections, and the reliability of estimates and judgements in these uncertain times. 

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Valuations are date-specific and rely on information or expectations that are already known at the valuation date. The pandemic has been a period of high uncertainty, impacting businesses on various fronts. The impact has resulted in businesses’ performance being more volatile, resulting in higher levels of risk, which in turn result in high investment return requirements from investors. This is in line with generally depressed asset prices across the globe. 

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Due to the uncertainty in the market, frequent valuations may need to be undertaken, particularly when in discussions with a potential investor, or when considering a transaction. Alternatively, other valuation mechanisms, such as deferred considerations, can be considered. This article, part of a broader report by I&M Burbidge Capital and PKF Kenya LLP, looks at the options for investors assessing value on a market comparable basis. 

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Impact on multiples 
Certain factors of valuation are impacted when it comes to experiencing volatility in the market. In this case, the coronavirus is the cause of impact. Some of the factors affecting asset prices on markets are: 

 

• Volatility in the global market – Significant market convulsions and increased volatility over the past couple of months will impact valuations in the form of higher discount rates. These rates will likely rise along with credit spreads and betas as investors become more risk averse. 

• Fall in Market Value - Valuation multiples such as price to earnings or Enterprise Value (EV) to Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA) are calculated for public companies using stock market prices. The recent decrease in market value in many countries has caused public company valuation multiples to decline. 

• Financial risk factors - The ongoing operational and economic uncertainties will likely lead to an increase in counterparty risk, and we may see a number of companies defaulting on their outstanding obligations. This will further increase the risk of investing through counterparties that either operate in high risk industries or have low credit ratings. The end of the first quarter of 2020 saw shocks triggered by the pandemic, which sparked panic selling by foreign investors. A trend that saw a 20.7% drop in the NSE 20 Share index, and similar corresponding declines in MSCI World, Emerging Markets and Frontier Market indices of 21.4%, 23.9% and 27.7% respectively. As at end of June 2020, foreign investors maintained net selling positions on NSE-listed equities. Private sector investors mirrored this trend with a slow-down in foreign activity as business conditions deteriorated. 

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As such, the general valuation considerations to put in place would include: 

 

• The short-, medium- and long-term impacts of the crisis, whether they be macro-economic or business-specific, will need to be taken into consideration. The market disruption observed today may be temporary, and the adjustments we make could potentially overstate or understate the crisis’ impact on the company’s valuation. 

• Fair value is based on what is known and knowable at the measurement date. The assumptions taken into consideration today may no longer be applicable tomorrow, which means that the procedures and rationale for any valuations you perform should be documented in full. 

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Thus, when applying the multiples approach, ongoing metrics and earnings should be looked at on a market participant basis and, therefore, one-off impacts can be excluded. However, expected adverse performance in Q1 and Q2 2020 and beyond, if deemed one-time, would still impact cash balances and would be reflected as a deduction from enterprise value in estimating fair value.

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An appropriate multiple should be congruent with the metric to which it is applied. The percentage change in Market Capitalisation of comparable companies may provide a good proxy for the magnitude of the change to be expected in the multiple. In addition, it may no longer be appropriate to consider application of recent transaction prices, especially those from before the expansion of the pandemic. An alternative cushioning would be to use an average of comparable trade and transaction multiples to average out any extremes. In time, data will be available on transaction multiples going back six months to the inception of the global outbreak of the pandemic.

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Impact on earnings 
While using the market-based multiples method, as outlined earlier, comparable transactions and trading entities within the industry, from similar market regions, are used in order to arrive at the valuation of a private business. Prices of listed entities are witnessing a downward trend, and therefore earnings of the valued business must be normalised in order to avoid under/over valuing the business. 

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COVID-19 related businesses such as health care, technology, PPE and sanitiser manufacturers are likely to see increased trading, resulting in better earnings, while other industries such as travel, leisure and hospitality are likely to face decreased trading and earnings. In both cases, the current trading scenario does not reflect normality and the process of normalising the earnings should be undertaken. 

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This is a process whereby all extra-ordinary items are excluded from the earnings in order to arrive at a sustainable level of earnings. One of the ways this could be arrived at, for mature businesses, is to use the average earnings over the past three years. The normalisation process differs for each company, dependent on various factors including life cycle stage, nature of operations, historical and projected performance, and key changes in the business during the forecast period, among others. 

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Further, revenue and costs can be extrapolated based on contracted revenue that has been delayed/cancelled due to the pandemic, in order to arrive at a normalised earning level. This is relevant to companies that generate contractual revenue, such as those supporting infrastructural projects funded by government agencies. 

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We present more perspectives on this and considerations for discounted cash flows (DCF) and other methodologies in our full feature report, available on the I&M Burbidge Capital website. The report also delves into the alternative transaction structures that mitigate some of the current challenges in executing transactions.

 

Rao is an Associate Vice President with I&M Burbidge Capital, Kenya.