Article written by:
Senior, Forensic & Dispute Advisory Services
Rebekah Smith, CPA, CVA, MAFF, CFF
Director of Forensic & Dispute Advisory Services
As COVID-19 has permeated every aspect of our lives, it is no surprise that the economic impacts of the pandemic will affect business valuators, too. As valuators prepare business valuations over the next few weeks and months, they will likely be giving extra consideration to:
- their use of subsequent events;
- their selection of valuation methods, and;
- the subject company’s cash usage rate and balance.
Strictly speaking, business valuations do not account for events occurring after the valuation date. Instead, a business valuation accounts for what was “known or knowable” as of the valuation date. As a result, valuators must decide whether to account for the economic consequences of COVID-19 in valuations with valuation dates (e.g., December 31, 2019) before the pandemic was declared in early 2020.
There are two main questions that will drive the answer:
- What is the valuation date?
- What is the purpose of the valuation?
Valuation Date Consideration
In determining if the impact of COVID -19 was known or knowable as of the valuation date, a valuation expert needs to understand the timeline of COVID-19 in the U.S. Most valuation experts believe that as of December 31, 2019, COVID-19’s impact was not known or knowable. However, for valuation dates through the first part of 2020, valuators will have to make an assessment based on the specific valuation date, the information that was known and available as of that date, and to what extent it should be taken into account in the valuation.
Purpose of the Valuation
If it was not “known or knowable,” then it is important to also consider the purpose of the valuation and the equity of either including or excluding COVID-19 impacts. In general, courts prefer to see real-world events (such as COVID-19) incorporated into valuations, and the standards allow disclosure of significant subsequent events. Specifically, the standards state that “in situations in which a valuation is meaningful to the intended user beyond the valuation date, the events may be of such nature and significance as to warrant disclosure in a separate section of the report in order to keep users informed.” Therefore, a valuation expert may include additional analysis and language explaining the impact of the subsequent event (COVID-19) on the performance and value of the subject company.
As with many other valuation decisions, whether to account for the COVID-19 pandemic in a valuation will be based on each valuation’s specific facts and circumstances.
Selecting a Valuation Method
Valuation standards require the analyst to consider all three valuation methods – the income, market and asset methods. However, the economic circumstances created by COVID-19 make some methods potentially more appropriate than others.
For example, under Discounted Cash Flows (“DCF”, an income method), the valuator projects the subject company’s future financial performance over a discrete period of time (usually five years). Under Capitalization of Cash Flows (“CCF”, another income method), the valuator picks a single income stream, generally based on historical results, to project future income. Because of the economic disruptions caused by the COVID-19 pandemic, DCF may be a more useful method when trying to model the future performance of a business as it allows the valuator to model future years individually as the business returns to more “normal” operations over time until it stabilizes. This method will still be challenging as a period of relatively increased uncertainty continues, and valuators may consider using multiple scenarios to model the business’s performance over the next 18 to 24 months.
This is not to say that the other valuation methods are not relevant; rather there are additional considerations that need to be made when applying the other methods. For example, when applying the market approach based on pre-COVID-19 transactions, the valuator will need to consider what adjustments, if any, are required to produce useful financial metrics to apply to the subject company in the midst of COVID-19. Valuators will likely not be able to simply gather a group of transactions from the prior three years, calculate an average and apply it to the subject company. The use of the market method may require more analysis and adjustments before using pre-COVID-19 transactions in post-COVID-19 valuations.
Cash Usage Rate and Cash Balance
Cash flow has always been a focus when it comes to valuations and the business’s ability to continue operations. COVID-19 has made cash flow that much more important. A valuator should consider the subject company’s cash balance and cash usage rate in assessing the company’s ability to continue operations. This also includes assessing changes the company has made to preserve capital during this time period as well as going forward. Doing so will give the valuator a good idea of how long the company may survive under the current situation. The consideration of the company’s longer-term prospects is also an important consideration when assessing the risks facing the company while determining a company’s discount rate.
Finally, some companies will have businesses that thrive in the COVID-19 environment because of the ability to take advantage of opportunities. Grocery delivery services, food delivery, manufacturers of PPE, and those who have retooled or reinvented themselves, may find that their business thrives and does better than in pre-COVID-19 periods. As the economy and consumer behavior changes, there were will be companies who can capitalize on this moment in time and do better than was originally anticipated.
Valuators are doing their best to consider the unpredictability of the current environment and evaluate key factors that require more emphasis than a typical valuation. When reviewing valuations prepared during this period, the reader should assess how the valuator addressed these issues in their analysis.
 American Institute of Certified Public Accountants Statements on Standards on Valuation Services 1; VS Section 100.43 (emphasis added).