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Risk Assessments in Valuation: More to Think About in Valuations during the Period of COVID-19. Comments and Points on Article in AICPA Review

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As an appraiser for 25 years, I have found it presently a challenging time to do valuations for clients.  An appraiser’s goal is to deliver credible, supportable valuations that reflect one’s best unbiased professional  opinion on the value of the subject interest or company.  How do we achieve this goal when we do not know when the world will normalize from COVID-19? 

The AICPA, on April 29, 2020, published an enlightening article by Josh Shilts, CPA/ABV, entitled “FAQs on Valuation Considerations When Valuing Distressed or Impaired Businesses.” In his article, Mr. Shilts addresses the difference between valuation uncertainty and distressed or impaired businesses, and the importance of not confusing these concepts when valuing a business, particularly in the context of economic upheaval like that caused by the COVID-19 pandemic.  I have highlighted some of his points (in quotes) and my comments (in italics).

1.  “For the current economic environment valuation, analysts should make sure to appropriately consider the impact of both non-financial and financial information (VS sec 100, paragraph 27 and 29, respectively).”  

  1. The takeaway is appraisers must not just consider the profit and loss of a business, but other non-financial factors, like staffing, customers, suppliers, etc. that will impact the financials.  These are the components of the business that allow it to operate. I recently valued a healthcare services company that was very successful going into the pandemic, but with the onset of COVID-19, it suddenly lost 90% of its business. The main concern of the owners was keeping the staff together and operations intact for when a normal level of business would resume.  A key risk factor was management’s ability to get a PPP loan and have the monies to tide it over while volume was significantly, but temporarily, reduced.   

2.  “The ability of management to obtain economic relief and their plans to manage liquidity, assets and potential debt, while adjusting for differing conditions with their supply chain, customers and industry.”

  1. As an appraiser, we must discuss with management what their plans are and what they are doing to handle the crisis.  How do they plan to reduce costs?  Do they believe they have the financial wherewithal to last an extended period of time with a significantly reduced volume of business?  What special arrangements have they been able to make with vendors, suppliers, lenders, and other stakeholders to allow them to reduce costs, ensure an uninterrupted supply chain, and decrease or defer debt payments?

3.  “The potential for companies to enter bankruptcy or a reorganization plan and the impact that such direct costs (i.e. attorneys, accounting, court, etc.) have on cash flows.”

  1. For some companies, a reorganization can be a saving grace and allow the company to continue operating while they restructure.  As an appraiser of such an entity, I would suggest an asset approach to valuation, considering the adjusted fair market value of the company’s balance sheet, including the net tangible assets and any real intangible assets (that have value) of the company.  What would the company’s net assets be worth in a worst-case scenario of orderly liquidation?  Some companies simply do not have the financial wherewithal to survive the pandemic and will go under.  In that case, the valuation approach required may be a forced or orderly liquidation.

4.  “Historical operating margins and the company’s balance sheet (i.e. solvency) to assess the future implications of a one-time, atypical event. The COVID-19 pandemic may have only short-term implications and strong companies may emerge stronger, while competitors with “heavy” debt obligations may need to close and/or liquidate assets”….”As stated by Aswath Damodaran in a recent blog he posted “I think it still makes sense to look at growth, profitability and reinvesting, pre-crisis, to get a sense of how much punishment companies can take. In businesses that already had anemic revenue growth, low margins and poor investment efficiency, the effects of the crisis will be far more devastating than in businesses with higher growth, margins and efficient investment.”

  1. Dr. Damodaran suggests evaluating the subject company’s pre-COVID-19 financial health to assess its ability to withstand the COVID-19 induced recession.  A company that had a good financial underpinning prior to the COVID-19 pandemic will likely weather the recession, whereas a company that was on shaky financial footing prior to the crisis is more likely to fail under the stressors of this one-time event due to the lack of strong fundamentals in the first place.

5.  “Consider the possibility the pandemic will produce an irreversible decline in either the relevant industry or for the client.  Certain companies will not survive, and the valuation analyst needs to consider this when reviewing companies in certain industries.  Damodaran states, “I looked at one factor that will determine survival risk, and that is the buffer that companies have on growth, profitability and reinvestment, with companies in higher margin businesses being more protected than companies in businesses with slim or negative margins. In this one, I look at the other factor that will determine survival and that is the debt burden on firms, since companies with higher debt burdens, other things remaining equal, will be more exposed to failure and distress than companies without those burdens.”

  1. Simply, Dr. Damodaran proposes a solid profit margin and no or low leverage as key indicators of whether a company will weather the recession or do poorly, and possibly fail.  However, it is likely, in the present circumstances, that certain low margin businesses such as  grocery stores, pharmacies and vehicles services businesses, will survive or even do quite well in the recession due to basic necessity of the products.   

6.  “Consider use of valuation models to determine the current pandemic’s impact on short-term and long-term cash flows. Consider varying cash flow models and assign a ranking based upon likelihood, probability, etc.  The uncertainty on the long-term impact of this market event is currently unknown.  However, valuation analysts can rely on data from similar historical events to create models that adjust cash flows and risks for varying scenarios.”

  1. A forward-looking model, such as a discounted cash flow model, showing the variation in future cash flows and ultimate stabilization is a good way to value a business in the current environment. If the appraiser estimates that there is a high likelihood of the business achieving the level of historical cash flows it had beforehand, because it is strong and can weather the recession impact, then doing a forecast of expected cash flows based on historical cash flow levels is a preferred methodology to determine value.

Some companies may come out stronger after the pandemic having simply survived it while their competitors did not.  Also, those companies with low or no leverage (debt) are better positioned to survive as well. Appraisers must think much more broadly and consider many more risk factors in the current environment, such as long-term viability, industry change, social distancing, customers, supply chains, etc., than before the pandemic.  Appraisers are well advised to exercise a heightened level of skepticism and conservatism in their valuations today. 

Monica Kaden, Sobel EAC Valuations