How COVID-19 and the War in Ukraine Are Affecting Property Values and Purchase Prices!
Currently, several global crises are having a significant impact on the German economy. Since 2020, the numerous waves of the COVID-19 pandemic have posed significant challenges, and since February 2022, Russia’s war of aggression against Ukraine and the sanctions imposed in response have also had massive economic repercussions. Further escalations cannot be ruled out. In particular, rising inflation rates, skyrocketing commodity and energy prices, supply chain disruptions, collapsing sales markets, and rising interest rates are taking their toll on many companies. As a result, several significant price drops have been observed in the financial markets, but the values of unlisted companies are also being affected by the increased uncertainty.
Enterprise Value Versus Purchase Price
The value of a company fundamentally reflects the future financial benefits from the shareholders’ perspective, typically in the form of the present value of the expected future financial surpluses that will result from the company’s continued operations (future earnings value). In valuation practice, the income approach and the discounted cash flow (DCF) method have emerged as the primary methods, both of which yield the same values under consistent assumptions. They derive the enterprise value based on a projected financial statement, in which the expected future financial surpluses are discounted to the valuation date using a risk-adjusted interest rate. Any non-operating assets are added as special value.
For low-profit companies, the prevailing view is that the liquidation value represents the lower bound of value. Simplified pricing methods using multiples, which are popular in transaction practice—particularly for small and medium-sized enterprises—are typically used by professional appraisers only to verify the plausibility of valuations based on the income approach or the DCF method.
By contrast, the purchase price for a company represents the outcome of a negotiation in which at least two parties have agreed on a purchase price to be paid, taking into account numerous individual factors (negotiating position, time pressure, number of prospective buyers, etc.). In practice, these factors often result in discrepancies between a company’s value and the actual negotiated price. Nevertheless, determining a company’s value should always serve as the starting point for all further considerations regarding the purchase price. Accordingly, it is important to determine the enterprise value in a robust, transparent, and verifiable manner, thereby creating a suitable basis for further strategic decisions—including making appropriate purchase price offers or evaluating offers received. Proper valuations can also play a decisive role in succession planning—for example, through gifts or inheritance—to avoid unexpected surprises during tax assessments.
Impact of the Current Situation on Business Valuations
Since company valuations primarily reflect a company’s expected future profitability and the associated risk, it stands to reason that many companies are currently experiencing declining valuations. Rising raw material and energy prices, as well as labor costs—which cannot be fully passed on to customers through price increases—along with supply chain difficulties are having an immediate negative impact on short-term results. At the same time, there is a high degree of uncertainty regarding the medium- and long-term outlook. The central banks’ shift in monetary policy in response to inflationary trends is also leading to rising costs of capital.
However, there are also cases in which individual companies and industry sectors are benefiting from current dynamic developments, as their business models are experiencing a surge in demand. Furthermore, the phasing out of COVID-19 measures is currently having a positive impact on numerous companies. An appropriate valuation therefore requires an individual analysis and assessment of the respective short-, medium-, and long-term effects.
Another fundamental principle for corporate valuations is adherence to the “valuation date” principle, according to which a valuation may only be based on the information that could have been obtained with reasonable diligence as of the valuation date. On this basis, for example, the effects of the war in Ukraine should not be taken into account for valuation dates up to February 23, 2022.
Which valuation methods are particularly suitable in this situation?
Dealing appropriately with uncertainty is generally one of the core tasks of a business valuation. In particular, the income approach and the discounted cash flow (DCF) method provide the appraiser with the best possible tools for this purpose. Since future profitability is typically derived from an integrated business plan—consisting of income, balance sheet, and cash flow projections —for a detailed multi-year planning period, assumptions regarding future development can be modeled while taking into account the specific market and competitive environment. In a subsequent perpetual annuity phase, a sustainable result is projected once a so-called steady state has been reached.
Scenario analyses and simulation techniques provide the valuator with various options for accounting for existing risks and uncertainties. In this process, the key value drivers can be presented in a transparent and traceable manner, and potential double-counting of risks in both the planning and the cost of capital can be avoided. The specific characteristics of small and medium-sized enterprises—particularly potential limitations on the transferability of existing earnings power—can also be appropriately reflected. Given the often-declined earnings power, liquidation values may currently be relevant more frequently as a lower bound for value and should therefore be examined more thoroughly.
In contrast, the multiplier methods—which are particularly popular due to their supposedly simple application—quickly reach their limits when it comes to accounting for current uncertainty. They determine enterprise value by multiplying a reference figure (in practice, usually earnings metrics such as EBIT or EBITDA, and in some cases revenue) by a multiple derived from comparable transaction prices or stock market prices. The benchmark figure can be derived from historical data or projected future figures. It generally refers only to a single period; all other growth assumptions are factored into the multiplier. It is therefore important that both the benchmark figure and the multiplier refer to the same time period. If historical data is used as a basis, there is always a risk that significant changes in future profitability will not be adequately captured. Particularly in the current situation, many distortions can be observed in the results of recent years.
Deriving the multiplier places very high demands on the actual comparability of comparable transactions and/or market prices, as well as on the timeliness of the underlying data. In practice, significant simplifications are often observed in the derivation of multiples; in some cases, arbitrary flat-rate multiples are applied to last year’s EBIT/EBITDA figures or the average of several years, which often results in a loss of connection to future earnings power.
If one were to account for the problem areas outlined above in a truly robust manner within the framework of multiplier methods, the amount of work involved would inevitably increase to the same extent as with the income approach or DCF methods. However, condensing numerous key value drivers (e.g., operational risk, financial structure risk, growth assumptions, etc.) into a single figure (the multiplier) inevitably results in severely limited transparency in the valuation.
The comparatively higher time and cost involved in determining income-based and DCF values should therefore always be viewed in light of the significance of the underlying economic decisions (such as the purchase or sale of the company or the selection of a tax-advantaged succession plan).
Conclusion
From a valuation perspective, it can be observed that the current market conditions and the resulting increased uncertainties highlight the fundamental strengths and weaknesses of common valuation methods even more clearly.
The income approach and DCF methods provide transparency and allow for appropriate, customized solutions. The determination of liquidation values as a lower bound for low-profit companies should also not be neglected. Multiplier methods, on the other hand, due to their significant simplifications, can easily lead to incorrect assessments, which severely limits their suitability as a basis for major economic decisions.
