Small Business Valuation Considerations During COVID-19
The COVID-19 pandemic has created immense challenges to valuation professionals when trying to determine the economic value of a small business. The dangers to human health presented by the novel coronavirus have forced government officials to issue unprecedented “shelter in place” orders all across the world, including the United States, in order to slow down the spread of the virus and prevent public health care systems from collapsing. In turn, these measures that required non-essential businesses to close have caused mass unemployment, a sharp collapse in consumer demand for certain goods and services while other goods and services that are essential, have faired better. These include groceries, alcohol, and firearms among others. The initial stages of the pandemic were categorized by sharp deterioration in consumer sentiment, an overnight shift in consumer preference, unemployment unseen since the Great Depression and massive uncertainty, combined with very aggressive stimulus from both central banks and governments. Now that the dust is starting to clear a bit, with restrictions being lifted and business starting to make a slow comeback, investors and entrepreneurs are considering selling existing businesses or purchasing new ones to better respond to the new reality. However, the future remains uncertain and that makes valuing any small business very difficult. In order to bring some clarity to the process we will examine what are the changes in the economic environment that are here to stay and how do they impact the valuation of small businesses.
Projecting Future Cash Flows The most important implications of the COVID-19 pandemic to small business valuation are related to projecting future cash flows. While there is little doubt the pandemic has hurt some industries such as leisure, hospitality, and airlines more than others the main questions of how much and for how long are still hard to answer. To determine how much revenues of a small might decline or increase in the future a valuation professional must make assumptions about the easing of lockdowns, whether there will be a second wave of the pandemic, what stimulus can the government and central bank provide, and how fast can the economy recover. Here the key to success would be to review industry specific literature and observe emerging trends. For example, the successful implementation of work from home policies would mean less demand for office space long-term and retail sales moving online will accelerated. In addition, when projecting future cash flows, valuation professionals should exercise sound judgment and consider the opinions of scientists and health care professionals. When modeling businesses in the hospitality, leisure and tourism industries analysts should consider that the minimum time to develop a vaccine for COVID-19 is about 18 months and no meaningful rebound can be expected prior to that. Overall, to get a realistic measure of future cash flows during the COVID-19 pandemic, a valuation professional should exercise sound judgment combined with both scientific data and industry specific data rather than looking at past trends.
Discount Rates At the onset of the crisis the Federal Reserve Bank responded quickly by lowering its target interest rate to 0-0.25% and restarting its quantitative easing program by purchasing massive amounts of US treasury securities and mortgage backed securities. That makes the risk-free rate, a major component of the discount rate, seem abnormally low. To get a more realistic valuation estimates, professionals should adjust the risk-free rate to reflect the long-term expected returns on US treasuries. That can be done by using a simple bult up model that combines the expected long-term real rate and expected inflation. As the US government has substantially increased its debt and monetizing it seems the only realistic option to deal with it, we can expect higher inflation in the post-pandemic world. After calculating the risk-free rate, a valuation professional must determine the equity risk premium as well the appropriate premiums to reflect the smaller size, lack of diversification and lack of liquidity that reflect the nature of smaller private businesses. All of these components have substantially increased since the COVID-19 pandemic started and more than compensate for the lower interest rates. The best approach would be to examine what premiums are required on micro stocks as a proxy for small business in order and inquire on the willingness of banks to finance small business in order to assess the perceived riskiness of small business as relative to its larger peers.
Market Multiples and Comparable Transactions The market-based approach to valuation has been considered accurate and useful tool for valuing small businesses. There are two methods under this approach, one is to use data from past transactions of comparable companies and the other is to use publicly traded companies as proxies to derive market-based valuation multiples such as enterprise value/EBITDA or price/sales. Since the start of the pandemic both methods face significant challenges. A waive of new retail brokerage accounts, 800,000 in total, has been opened since the start of the pandemic by retail investors. During the preceding years these investors have been priced out of buying opportunities and now saw the crisis as an opportunity to both make use of their time during the lockdowns and to make quick profits during the recovery. However, their lack of expertise has fueled a wave of speculation in the stock market, leading to a rally that is unsupported by fundamentals and that has pushed stock market valuations as measured by price/earnings and EV/EBITDA to all time highs. Since the beginning of March until the date of this article (June 11th, 2020) the stock market has experienced severe volatility that makes market multiples change too quick to be meaningfully used in any valuation analysis. The comparable transactions method which relies on past transactions to derive valuation multiples is challenging to use in small business valuation. Some companies provide reliable databases of past transactions that include not only publicly traded companies but also smaller private businesses that have disclosed their data. While normally very useful these databases now present a challenge to valuation professionals in that pre-pandemic data can only be used for industries that are neither much negatively impacted or positively impacted by the pandemic. With those industries being far too few most of the times the only somewhat useful data would come from transactions initiated after the start of the COVID-19 pandemic. As those transaction are too few as of now and with huge uncertainty surrounding the reopening process it would be best to steer clear of market-based approaches.
Overall, small business valuation during the COVID-19 pandemic requires precise work that relies on scientific data, careful industry analysis and sound judgment.
If you need valuation for a small business, whether you are looking to purchase one, sell one or need to obtain debt or equity financing, contact us – Key Reef Financial, your certified valuation professional.