The income approach, which frequently takes the shape of a Discounted Cash Flow (DCF) valuation method, is one of the most prevalent approaches to business or property valuation. The income approach is a generally established method in the field of valuation, and one of the key approaches used in determining a commercial enterprise value or asset prices. Even in normal circumstances, tiny adjustments to one of the many assumptions or inputs that make up an income approach valuation model’s base can have a big impact on the model’s results. In paragraphs 6.157-6.158 of the OECD Guidelines, the following statement is made: “Small modifications in one or more of the valuation model’s assumptions, or in one or more of the valuation parameters, can result in significant variances in the […] value the model generates.” As a result, “value necessitates defining realistic and credible financial estimates, growth rates, and discount rates, among other things…” COVID-19’s financial impact must now be factored into the valuation process. The parts that follow detail some valuation assumptions, as well as any adjustments that may be required in your approach due to economic uncertainty and volatility.
Accounting For COVID-19: 4 Modifications To Consider
1. Discount Rates
Risk and the time value of money of predicted cash flows are factored into discount rates. While the facts and circumstances of each study must be taken into account on a case-by-case basis when determining a discount rate, the Weighted Average Cost of Capital (WACC) is one of the most commonly utilized methods. We can look at some of the inputs to a WACC calculation and see whether they need to be adjusted as a result of recent events.
Due to the very low price of government securities and volatile market conditions, the inputs to a WACC without adjustment or normalization could result in a relatively low discount rate. Heightened valuations would result from a lower discount rate, which would be counterintuitive and may not represent higher risk levels for many enterprises during the COVID-19 crisis.
Before altering the WACC, it’s critical to comprehend the crisis’s impact on the firm and industry. Customers, sales, staff, business continuity, and the supply chain are all factors to consider. A slightly affected industry, such as healthcare REITs, may be facing small disruptions in the near or medium term, and the discount rate is unlikely to have changed significantly from a few months ago. Other industries, such as the aviation industry, have been severely impacted, with difficulties such as fewer customers, trip cancellations, route constraints, and other service disruptions.
Once the situation of the business is known, it’s critical to make sure that the assumptions utilized accurately reflect the crises’ impact. Longer-term averages and inputs that represent more normalized economic conditions are more acceptable when there is less exposure to the crisis.
2. Financial Forecasts
Forecasting strategies vary by industry and typically incorporate both direct and indirect procedures (sometimes known as “top-down” and “bottom-up” approaches). Modeling sales projections, for example, can be done at the entity or business unit level, and then the forecasts are combined to generate a consolidated forecast (i.e., bottom-up). Operational expenses (e.g., overhead and administration services) may benefit several business units in different ways. These costs should be allocated appropriately from a company-wide projection (i.e., top-down). Choose your forecasting methods carefully and keep track of them for future reference.
Both the OECD Guidelines and the US Regulations imply that estimates created for non-tax company planning purposes are more credible than projections prepared only for tax or transfer pricing purposes for valuation and transfer pricing purposes. As a result, consider collaborating with other divisions within the company to generate or assess the company’s non-tax estimates during the COVID-19 crisis. Make sure that predictions match the analysis’ valuation date and that no things from before the epidemic are included.
Paragraph 6.173 of the OECD Guidelines also warn that:
“Certain risks can be taken into account either in arriving at financial projections or in calculating the discount rate, care should be taken to avoid double discounting for risk.”
Avoid combining a normalized discount rate with normalized projections, thereby ignoring the consequences of the current market conditions entirely.
3. Growth Rates
Paragraph 6.169 of the OECD Guidelines states:
“It would generally be expected that a reliable application of a valuation technique based on projected future cash flows would examine the likely pattern of revenue and expense growth based on industry and company experience with similar products.”
While future market conditions cannot be predicted, post-COVID-19 valuation modeling should account for the likelihood of a flat or recessionary economy. The degree to which growth is influenced is also determined by the products, industry, and what is valued. Consider the commodities or services in the perspective of demand elasticity. Is demand for products or services higher or lower when the economy is doing well? If feasible, look into the company’s performance during periods of economic turmoil for more information. Finally, think about a longer prediction period that includes a possible economic rebound, after that, a “normal” rate of terminal growth might be assumed (if applicable).
4. Sensitivity Analysis
Make sure to stress test the valuation results under various circumstances during this particularly volatile time (e.g., expected, worst-case, better-case). (Please retweet!) The application of appropriate valuation methodologies should be carefully scrutinized. Consider which inputs and assumptions can be bent to approximate a reliable result (or, where applicable, an arm’s length range of results). There are various alternatives, including discount rates, growth rates, financial ratios, rate spreads, and probability weightings. Whatever scenario is chosen, make sure to carefully explain the reasoning and assumptions.
In general, the difficulties described above should serve as a good beginning point for things to examine when valuing during this crisis. Particularly as the financial impact of COVID-19 continues to develop, creativity and practicality are crucial components of values.