Not only have political measures and economic conditions changed, but people’s behaviors have also changed or must adapt to new circumstances. This affects production and supply chains, as well as related cash flows, and ultimately the financial metrics of companies.
Even after more than two years, the course of the COVID-19 pandemic, its resulting consequences, and their duration remain difficult to assess. Forecasts made just weeks or months ago can quickly become outdated, thereby increasing uncertainty in planning.
This poses particular challenges when it comes to preparing planning projections or making assumptions required for a business valuation. The value of a company is based on the forecast of future cash flows and thus represents a determination of future success that is verifiable on an intersubjective basis.1 Business valuators are currently faced with the question of how to handle the forecasting of future cash flows and their impact on the cost of capital against the backdrop of these crises.
What is the true value of a company under the current conditions? What role do the ongoing COVID-19 crisis or the war situation play in conducting a business valuation? Against this backdrop, how should one currently approach important business decisions, such as the sale of the company?
Numerous Occasions for Business Valuations Due to Unplanned Succession
According to the DIHK, the issue of unresolved business succession continues to gain prominence.2 However, in many cases, crises lead to uncertainty, a shift in priorities, and the postponement of this issue on the part of business owners, causing the number of unresolved succession cases to rise further. At the same time, due to the situation in the capital and labor markets, there has been a significant increase in the number of potential business buyers. Entrepreneurs who act countercyclically now can seize the opportunity presented by the current crisis to explore attractive options for planning their own succession. It is not uncommon at present for SMEs to be successfully sold through a bidding process. A key prerequisite for achieving this goal is a solid, objective business valuation that also takes into account the current conditions under COVID-19 and crisis scenarios and makes their effects transparent.
Impact of Crises on Business Valuation
When comparing the COVID-19 pandemic to other crises, it is clear that the consequences of this crisis, too, are highly likely to continue to subside. The question at present is: “With what probability and intensity will the crisis resurface?” In valuation methods focused on the long term—such as the income approach—the negative effects of a crisis will generally be put into perspective.3 However, in simplified and modified income approach methods that rely on historical data and use shortened profit periods, the crisis can have a significant impact on the company’s development and value, depending on the industry and business model. It is not uncommon to find cases that have been particularly hard-hit by the pandemic. In such cases, often only the liquidation value remains.
In this regard, when conducting a business valuation “in times of crisis,” it must first be determined to what extent and at what point the business is affected by the crisis and should therefore be classified as a “business in crisis.”4 The assessor must evaluate the detectability of the effects on a case-by-case basis. In doing so, reference must be made to relevant factors such as the specific business model, the scope of operations, and the location of the company being valued. In the case of a company affected by the crisis, the effect on enterprise value, according to IDW, results primarily from the adjustment of future cash flows.5 But does the perceived risk and market uncertainty also lead investors to demand risk premiums, and might these potentially affect the discount rate used in a business valuation?
Scenarios for Planning Future Cash Flows
Risks must generally be taken into account in both the numerator (revenue projections) and the denominator (capitalization factor) in the context of business valuation. The business valuer is first advised to examine multiple scenarios when developing projected figures and to structure these scenarios according to their severity and duration. However, rather than considering every conceivable scenario, ideally no more than three scenarios should be identified. According to the IDW, until recently, three scenarios regarding the future course of the pandemic were under discussion: An immediate recovery (“V-shaped trajectory”), a delayed recovery (“U-shaped trajectory”), or a long-term negative trend (“L-shaped trajectory”).6
Regarding the likelihood of these three scenarios, the U-shaped trajectory currently appears comparatively probable given the advanced stage of the pandemic, the availability of vaccines, and the easing of the pandemic’s course. This raises the question of exactly how—or over what time horizon—the “U” is defined. It must be emphasized that the consequences of the crisis must be analyzed on a company-by-company basis according to industry, markets, and business model, and taken into account in corporate planning and the respective scenarios. Government grants and support payments must be treated as one-time effects in the respective planning years and adjusted accordingly.7 If an industry—such as retail or tourism—is likely to be affected by the long-term consequences of the crisis, for example due to a fundamental shift in consumer behavior or sales channels, these effects must also be analyzed and factored into the plan on a case-by-case basis.8 In this context, the “perpetual annuity” approach in particular should be critically examined.
Although many small and medium-sized enterprises still do not conduct standardized business planning, special attention should be paid to this now more than ever. This is particularly true in the event of an impending business succession, the planned sale of the company, or the securing of urgently needed financing.
Critically Analyze Cost of Capital
The discount factor (denominator) used in the income approach to discount the company’s future profits to the valuation date should be examined in light of the current crisis. Interest rates are currently rising. This tends to result in lower company valuations based on the underlying base interest rate. When determining the cost of capital, the question also arises as to whether the uncertainties associated with the pandemic have led to higher return requirements from equity and debt providers. However, this has not yet been evident over a longer period of time. In this context, the IDW points out that, within the framework of long-term future earnings-based valuation methods (income approach), capital market data must be assessed based on long-term analyses of returns, even in times of crisis. Short-term fluctuations and possible exaggerations in the capital markets should be classified as temporary—and not necessarily long-term—indicators of market sentiment.
Therefore, the IDW concludes that even during a crisis, the capitalization rate continues to be based on long-term analyses of returns, which are observed in the range of 7.0% to 9.0% (after corporate taxes and before personal taxes). The IDW currently continues to view the market risk premium as ranging from 6.0% to 8.0% (also after corporate taxes and before personal taxes). Consequently, the IDW sees no need to adjust the existing methodology for determining the cost of capital.9 It should be noted here that, given the fundamental assumption that uncertainty has increased, this would also need to be reflected in the risk premiums of the income approach, as long as one wishes to adhere to the standard guidelines of the method. Therefore, even if it is difficult to prove empirically, the emergence of risks (such as a pandemic of a kind not previously seen) should increase risk perception and thus risk costs.10
In particular, a change in the company’s debt situation resulting from the crisis must be reflected in the capitalization rate via the beta factor. In this respect, it is already apparent that certain industry-specific beta factors are changing as a result of the crisis. However, according to leading valuation practice, blanket risk premiums on the capitalization rate should not be applied at this time.11
Conclusion and Recommendations
Overall, the effects associated with the current crises—particularly the COVID-19 crisis—are initially creating significant uncertainty regarding the assessment of companies’ future performance. This makes it difficult for the valuator to forecast future earnings and apply established income-based valuation methods. This should be addressed primarily through appropriate planning scenarios. Particularly with regard to the valuation of small and medium-sized enterprises, the valuer must generally take into account specific characteristics and risks, such as dependence on the owner, on a major customer or supplier, as well as the interdependence with the owner’s private life or a specific location risk.12 These must be transparently justified in the valuation through cash flow projections (numerator) and the shortening of the earnings period.13 The current crisis and pandemic situation present an additional challenge. The additional risk adjustment to the capitalization rate should be assessed on a case-by-case basis.
Since business valuation and the associated determination of the purchase price always involve a long-term perspective, the issue of COVID-19 in particular will be only a part of the enterprise value both now and even several years from now. This exceptional situation may, depending on the specific case, lead to lower enterprise values—but in most cases, this will not result in a sharp short-term decline in enterprise value. It is important to position oneself appropriately in planning based on the specific circumstances and to account for the various factors affecting the respective company in a transparent manner within the valuation.
In the context of a business sale, this uncertainty increasingly results in variable purchase price components (earn-out structures) or discounts on the base purchase price. At the same time, however, the large number of potential buyers currently in the market presents a very good opportunity to sell one’s company on fair and reasonable terms. It is therefore advisable, even in times of crisis and the associated rise in interest rates, not to postpone important business decisions—such as planning for business succession—but rather to weigh the opportunities and risks on a case-by-case basis.
Sources:
1) IDW S 1 (as amended in 2008), para. 29.
2) DIHK Report on Business Succession 2020.
3) Technical Note from the IDW Expert Committee on Business Valuation and Business Administration (FAUB) dated March 25, 2020.
4) Technical Guidance from the Chamber of Tax Advisors and Auditors on the Effects of the Spread of the Coronavirus (COVID-19) on Business Valuations (adopted by the Executive Board of the Chamber of Tax Advisors and Auditors on April 15, 2020, para. 5).
5) Technical guidance from the IDW Technical Committee on Business Valuation and Business Administration (FAUB) dated March 25, 2020.
6) Technical guidance from the IDW Technical Committee on Business Valuation and Business Administration (FAUB) dated March 25, 2020.
7) Bartl/Patloch-Kofler/Schmitzer, “Impact of the COVID-19 Crisis on Business Valuation,” RWZ 4/2020, LexisNexis.
8) Technical Guidance from the IDW Technical Committee for Business Valuation and Business Administration (FAUB) dated March 25, 2020.
9) Technical Note from the IDW Technical Committee for Business Valuation and Business Administration (FAUB) dated March 25, 2020.
10) Criticism from valuation practitioners, e.g., covendit.de/2020/09/30/the-impact-of-the-coronavirus-crisis-on-cost-of-capital-for-business-valuation/
11) Technical Note from the IDW Expert Committee on Business Valuation and Business Administration (FAUB) dated March 25, 2020.
12) BVS Position Paper on the Valuation of Small and Medium-Sized Enterprises (SMEs) 11-2017, Section 3.4.
13) BVS Position Paper on the Valuation of Small and Medium-Sized Enterprises (SMEs) 11-2017, Section 5.4.2.
