Business Valuation Insights Post COVID-19
More than three years after COVID-19 changed the world, business valuations are returning to normal. In many instances, historic valuation inputs, specifically past performance, cannot be taken as an indication of future performance. In addition, market volatility driven by supply chain disruptions, rising interest rates, and inflation, have only served to complicate matters.
In normal times, getting an accurate valuation of a business or other asset can be challenging. There are multiple inputs that must be considered and a value derived based on various assumptions. In disputes, two experts can arrive at quite different values depending on the calculation method. Now, there are several other considerations for valuation experts and business owners to weigh. To help clients, prospects, and others, Smith Schafer has provided a summary of 2023 issues impacting business valuations below.
Risks and Market Conditions
COVID-19 created significant market risk for companies during and after the height of the pandemic. Ongoing risks that need to be considered range from the larger economic environment in which a company operates to credit, liquidity, and forecasting risks.
For example, businesses in some industries may never see the same level of economic demand or production. The same can be said for companies whose demand surged as for those who saw revenue drop substantially. The resulting impact to future cash flows can be unstable and is a significant risk that needs to be considered in a valuation.
And even now, short-term financial and economic forecasts are still uncertain. Rising energy and material prices are affecting the bottom line and further straining company budgets. It’s important for businesses, especially those exposed to a global supply chain, to account for forecasting risk in a valuation.
Inflation and the Rising Interest Rates
Since January 2023, markets have become increasingly volatile, reversing a trend that appeared to mark overall economic growth and recovery. Rising interest rates and the threat of inflation are causing the cost of capital to go even higher. Long-term inflation estimates in the U.S. increased from two percent at the height of COVID to 2.5 percent as of June 2023. For valuations, inflation expectations play heavily into the discounted cash flow method (DCF). It also means that businesses may find it harder to create and preserve value.
And with a predicted recession in 2023, business owners with an eye on an upcoming transition will need to do their best to stay ahead of inflation. McKinsey data suggests that to do this, earnings need to grow faster than the rate of inflation, which can be hard for most companies to achieve.
It’s estimated that 80 percent of current business owners will plan their exit in the next 10 years. As the process unfolds, some of the traditional paths are already going by the wayside.
In business sales, finding strategic buyers isn’t the main priority for most sellers anymore. A Deloitte study found that only 37 percent of potential sellers identified strategic buyers, compared to 52 percent pre-COVID. Additionally, new business combinations and alternative transactions are beginning to replace traditional buy-sell agreements. More businesses are restructuring, which includes reorganizations, changes to working capital, cost reduction, and legal entity changes.
For buyers, access to labor and technology are two driving factors. It’s becoming more common to see buyers snap up companies not for assets or market share but for talent. Strategic partnerships that result in new capabilities are also happening more.
In all these transitions, an accurate, reliable, and current valuation is necessary.
The message here is that what was once a typical valuation transaction is far from guaranteed. Business owners will need to consider their goals for the transaction more than ever. Depending on the outcome, there may be multiple ways for a valuation to support that goal. Talking with a business valuation advisor first can help to ensure the valuation process and methodology aligns with the result.
Public market valuations, which are often seen as a precursor to private and smaller markets, are changing. Multiples for smaller companies are often higher than for larger entities. This is especially true for tech companies that trade based on multiples of revenue and not EBITDA. As revenue expectations are still hard to develop, it can be difficult to forecast the next six months if it’s unclear whether COVID performance was an anomaly or an indicator of future performance.
Using forward-looking multiples to evaluate business value can in some cases better reflect risk-related pricing and earning impact.
Overall, the focus now seems to be more on forecasts and budgets and less on past results. Consideration needs to be paid to more than just the entity. It’s important now to evaluate all inputs and variables affecting output. The more inputs that the company can control, the more exact and reliable the valuation. A cost or asset valuation approach may be a better indicator of performance in the current environment, though each situation is unique.
It’s also worth noting that more guidance for valuation considerations is likely to be released before the end of 2023. One piece of guidance that’s currently in development concerns estimating the discount rate for the fair value measurement of intangible assets.
Next, the discounted cash flow method (DCF) is being questioned for its use in business valuations. Analysis suggests that DCF can be used to value bonds, but not businesses because it cannot accurately represent “the causal mechanisms behind market values.” This is an interesting development because many valuation experts used DCF during COVID due to its very nature of capturing the net present value of cash flow.
Finally, regulatory requirements to include Environmental, Social, and Governance (ESG) factors need not be included in the cost of capital this year – but that could change in the future. Nevertheless, more buyers and sellers are considering ESG effects on valuations now.
Valuation approaches post-COVID are as varied and unique as the entities and assets they look to value. A single approach does not work for all transactions, and especially now there is an even greater need for careful, objective analysis. If you have questions about the information outlined above or need assistance with an asset of business valuation, Smith Schafer can help. For additional information, click here to contact us. We look forward to speaking with you soon.