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Since February 2020, the world has been facing unprecedented crises due to the spread of Covid 19 pendamic and the subsequent lockdowns imposed by various governments. This has caused massive disruptions in the normal business activity and has led to restrictions on the movement of people. This was followed by crash in the stock markets around the world on account of considerable uncertainty on the length of lockdowns, and the road to normalcy for the business enterprises. The economic scenario and sentiments are dampened, supply chains are disrupted, demand is contracted and job losses around the world.
Valuation is an economic concept and various valuation approaches provide only an estimate of value based on the assumptions involved. All valuation approaches use some degree of market data to arrive at a fair value. Since markets around the world have been disrupted, the pre-Covid data points may not be relevant anymore while new data points will take time to stabilize. The actual impact on the fair values would vary from industry to industry and case to case basis. In general, considering the fall in equity markets, the valuations seem to be reduced by at least 10-20% across the board considering the impacts on expected market risk premiums, market multiples and future cash flows and availability of willing buyers in the market.
Let us consider the inputs and the variables used in the various valuation approaches for analysing the impact of Covid 19 on valuations.
The basic inputs for valuation under the cost approach of valuation are as follows:
Market Values of an asset are driven by demand and supply of the asset. Demand is driven by the economic utility of the asset and the capacity and willingness of the buyers, E.g. the demand for commercial real estate or office space is expected to reduce considering the tactical shift by companies to incorporate work from home option as part of their policy and cost containment measures. Similarly the demand for a particular plant and machinery asset will depend on the ultimate demand of the end product it produces.
While there may not be much impact on depreciation for physical or functional obsolescence, depreciation on economic obsolescence, in addition to the demand and supply factors, is impacted by the disruption or loss of supply of labour or raw material and ability of the business to generate economic return from the asset.
The basic inputs for valuation under the income approach of valuation are as follows:
Expected future cash flows have been affected by lockdowns and demand scenarios. A valuer will have to assess whether the impact on demand is temporary or permanent in nature. A valuer will also have to assess whether there are any structural shifts in the customer behaviour. It would be ideal for the valuer to use scenario analysis for forecasting the cash flows.
Estimating the appropriate discount rate again requires a careful analysis of its components. While the risk free rates have reduced, the market risk premium has increased. The company specific risk premiums are impacted considering the liquidity positions of the company in addition to any other company specific risk. Due to the increased volatility in stocks, the market risk represented by beta is also increased. Another factor to be considered is mix of equity and debt in the discount rate. With the tightening of the liquidity position of the company, it is expected that there will be lesser debt available to the company and hence the ratio of equity should increase. This will in turn increase the discount rates.
The basic inputs for valuation under the market approach of valuation are as follows:
The market multiple is dependent on two factors. First is the market price which is reduced in most cases and the second factor is the company variable of the peers. The company variables are also expected to reduce for trailing twelve months and next twelve months for most industries considering the disruptions in the normal business operations. Hence, the impact on market multiple will depend on the degree of impact on the stock prices vs the impact on the company variable. If the decline in market prices is less than the expected decline in earnings, EBITDA, etc then the market multiple will actually rise giving an impression of higher valuation.
Post Covid 19 scenario, there is very little data available on the premiums and discounts applied to the multiple as the number of transactions to base such assumptions on are very less. Nevertheless, it will remain on the judgement of the valuer to apply the quantum of such premiums and discounts.
The revenue, EBITDA or earnings of the company being valued are also impacted and hence valuations.
With the ever changing market scenarios and increasing regulation, it is difficult to be a valuer especially when the regulators and other stakeholders expect them to be like gods who will give a perfect fair value of assets under any condition. To safeguard the valuations, it is advisable for the valuers to take following steps:
In this article we have tried to get to the granular level to understand how the situation emerging from Covid 19 pandemic and subsequent lockdowns has impacted valuations. In subsequent articles we will analyse the quantitative impact of covid 19 on these variables.
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