Now What?

Thinking Through the Valuation Implications of COVID-19

As business valuation professionals, we are required to project the economic future of a business. In the past, valuation professionals used many sources of information to reduce the uncertainties inherent in valuation, key among them: 1) past performance, 2) industry reports, 3) company and/or stock sale data, and 4) cost of capital data. Now, valuation professionals are suddenly faced with these resources having lost much of their predictive value and reports are due. Throwing up one’s hands is not an option. Since very few valuation professionals have the prognostic abilities of Nostradamus, the alternative is to go back to the basics and ask what influences a company’s success or failure. This article provides a framework and examines what valuation professionals should consider given that the past is no longer considered a good indicator of what may happen.

As business valuation professionals, we are required to project the economic future of a business. In the past, valuation professionals used many sources of information to reduce the uncertainties inherent in valuation, key among them: 1) past performance, 2) industry reports, 3) company and/or stock sale data, and 4) cost of capital data. Now, valuation professionals are suddenly faced with these resources having lost much of their predictive value and reports are due. Throwing up one’s hands is not an option. Since very few valuation professionals have the prognostic abilities of Nostradamus, the alternative is to go back to the basics and ask what influences a company’s success or failure.

Any big shocks to the equilibrium of markets and the economy at large will create ripple effects, especially when that shock is global, and that will create opportunities for some and curtail them for others. Therefore, like most things, there is no one-size-fits-all approach. Our task as valuators is to analyze all the areas in which changes have occurred and try to quantify both the impact of these changes and how long the effects will last. In some cases, the changes may be permanent. For instance, in most industries prior to this pandemic, the idea of a large percentage of the workforce working from home was not very popular. But now millions of workers have been forced to do exactly that; and while some loss of productivity may have occurred from having family present while trying to work, many people may be more productive because they do not lose time commuting and they may be able to manage interruptions better at home than at work. (Yes, I realize that may not be true for those with small children.) But now that COVID-19 has forced this huge social experiment and the technology enabling people to work from home is in place, I suspect more companies will consider letting people work from home, at least on a part-time basis if productivity has remained the same or even improved.  

With the preceding in mind, we can start by looking at all the ways the outside world affects businesses. There are ten main areas we can assess when strategically analyzing a company’s environment. They are:

1) Economic

2) Political/Governmental

3) Demographic

4) Psychographic (Social/Cultural)

5) Legal/Regulatory

6) Technological

7) Industry (look at key success factors)

8) Competitive

9) Environmental (green trends)

10) International (if applicable)

Dr. Michael Porter, the Harvard Business School professor known for his economic and business strategy theories, suggests a different way of looking at these same forces, categorizing them as: 1) the bargaining power of customers, 2) the bargaining power of suppliers, 3) threat of new entrants, and 4) threat of substitutes. There is a lot of overlap between the ten areas and these four categories but using both frameworks can assist with thinking through the changes from more than one perspective.

Here are some things to contemplate as you assess the impact COVID-19 may have upon the business you are valuing:

Economic Considerations

• How long is this business expected to be operating outside of its normal parameters (different hours, only partial services offered)? What will be the short-term effect on sales and costs?
• Are the services or products provided time-dependent? For example, hair salon and pest control services are rendered as needed. No one is going to get two haircuts in one month because he or she missed the previous month. Conversely, some businesses may get a temporary bump when people are finally able to socialize again—restaurants, movie theaters, retailers, etc.
• For some businesses, like companies that make hand sanitizer or masks, the short-term effect will be positive. So how long will that effect last? Many have theorized that COVID-19 may come around again in the fall and some expect even after COVID-19 abates, people will be much more cognizant of hygiene in general.
• Other businesses, like Netflix, have experienced tremendous gains. How much of that gain will be lost once the restrictions are lifted?
• Still others have diversified into related businesses, for instance, some alcoholic beverage manufacturers are now making hand sanitizer. Think about whether this is a temporary situation or a permanent change in the business model.
• Are there any suppliers that are expected to go out of business and what will that mean for costs going forward? This factor could be positive if the remaining suppliers are competitive and looking to make up for lost business, or it could be negative if there are few remaining suppliers for a product or service with no viable substitutes.
• What additional costs will be incurred for sanitizing?
• What additional costs will be incurred for protective equipment for employees, contractors, and maybe even customers?
• How will curbside pickup services impact the business and for how long? The pickup option was already becoming popular but generally required the consumer to go into the store. Will consumers expect this level of service to continue? If so, will the business be able to charge enough to cover these costs?
• If delivery services are currently being offered, is the business planning to continue to deliver? If so, what will they charge for that service after the crisis has ended and will customers be willing to pay it?
• Will employee sick pay be instituted or expanded?
• How much will health insurance costs increase in general?
• Is there a plan in place if there is a shortage of employees due to illness (or even fear of illness)?
• If there is significant contact with the public, will the business need to raise wages or offer bonuses in the short-term? Could that result in a long-term change in compensation?
• Will essential workers who are not being offered health insurance leave for jobs that do offer it? This and other factors may lead to increased competition for the best employees.
• How much will unemployment taxes go up?
• Will the business be able to either retain or rehire the workforce it had?
  • If so, are there additional one-time costs incurred for things like setting up the structure to work from home or paying idle or under-utilized employees? Any offsetting savings?
  • If new employees are needed, what additional recruitment and training costs need to be considered? In the meantime, will short-staffing affect sales?
• Could there be additional expenses due to delays in providing products or services? For example, the construction industry often has contractual completion deadlines with penalties for missing those deadlines. Certain construction tasks that require good weather to complete could be pushed out by several months. In addition, a delay may mean required materials could be more expensive by the time they are needed.
• Will additional working capital be necessary? For businesses that extend credit, cash flow may be impacted by customers paying slower than usual.
• Will additional capital investment be necessary for such things as purchasing sterilization equipment and putting up plastic barriers?
• Does the business even have the financial resources to survive?
• Is business interruption insurance in place? If so, is there a force majeure or other exclusionary clause precluding a payout and if not, what amount of funds could be expected and when? Keep in mind most insurance companies are rejecting these claims and a forensic accountant may be needed to quantify and justify the amount of the claim.
• Is the local economy better or worse than the national economy?

Political/Governmental Considerations

• Did this business secure funding under one of the government programs to stabilize income? If so, what are the conditions for the loan and how much will it likely have to pay back? (Consider that the cost of capital may be lower in the short-term because of these loans.)
• If COVID-19 rebounds after restrictions are eased and/or in the fall, will restrictions be put in place again? If so, will more financial aid be available at either the federal or the state level? Keep in mind the restrictions may vary greatly state to state or even county to county.
• How will the upcoming elections affect the business? No one knows who will win but recent polls suggest it is increasingly likely Democrats will score major victories.
• Will the state or local government raise taxes to cover projected shortfalls?

Demographic Considerations

• For consumer-oriented businesses: What is the composition of the core customers? Are they affluent, living paycheck to paycheck, or somewhere in between? How have they fared economically?
• For B2B businesses: How has demand changed for the products and services customer companies offer? How financially stable are the customer companies? This is especially important for businesses with heavy customer concentration.

Psychographic (Social/Cultural) Considerations

• Have consumer preferences changed as a result of the quarantine? For example, someone who never cooked much before has gotten used to cooking and may frequent restaurants less than he or she did previously. Other people may have started cutting or coloring their own hair and decided that is a way to economize in the future. Keep in mind these trends might be temporary and cease once consumers feel economically stable again.
• As mentioned previously, online shopping was already an established trend, but recent surveys indicate the quarantine has accelerated this trend. The National Retail Federation’s 2018/2019 Winter Consumer View cited the growing popularity of the buy online and pick up in store (BOPIS) option. How well positioned is the business to capitalize on this trend?
• Are people feeling anxious about spending, even if they are affluent? Some people will spend less because of the stock market decline, even if they have sufficient money in the bank. Many will undoubtedly feel the need to increase the amount of their savings.
• How long will consumers in general remain fearful of large gatherings? If you are valuing an events business, this could be a significant factor.
• If working from home becomes more commonplace, how will that affect other businesses? Restaurants may experience decreased lunch time sales and less commuting will put downward pressure on gas prices. Clothing retailers may see sales decline as well.

Legal/Regulatory Considerations

• What legal restrictions have been placed on operations? Is the business closed or are hours of operation or offerings restricted? When are those restrictions expected to be lifted and in what manner—removed all at once or in phases?
• Even if the business is allowed to resume operations, social distancing is expected to continue for most or all of 2020. How will these restrictions affect the volume of sales? Businesses like restaurants and theaters will not be able to utilize their full capacity.
• Will extra personnel be required to enforce social distancing? For example, Trader Joe’s has someone stationed by the front door to sanitize the shopping carts and limit the number of customers who can be in the store at one time.
• Is the business handling the pandemic in a manner that may result in lawsuits from customers, employees or contractors?

Technological Considerations

• How well adapted is the business to selling online, especially in comparison to its competitors? Businesses that have seamlessly transitioned to online sales have fared much better than those that did not.
• Is the business set up to accept multiple alternative payment options such as PayPal, Venmo, Apple Pay, Google Wallet, Square, etc.?
• For non-retail businesses, is the technology in place to allow its workers to easily work from home and collaborate with colleagues? How secure are those platforms? There have been problems with hackers obtaining sensitive company information during unsecured video conferences hosted by Zoom.
• What costs are incurred in setting up employees to work from home? Consider such things as adding IT staff, increasing Internet capacity, enhancing security protocols, and conferencing and collaboration platforms. Will the business be providing or subsidizing additional cell phones or home Internet service?
• If the business needs to either implement or enhance its online capabilities, like offering buy online and pick up in store service, how long will it take and what capital investment is necessary? What will be the short-term effect on sales in the meantime? Are there any additional long-term costs, such as website improvements, increasing bandwidth, enhancing online security, or maybe even cost savings from doing more business online?

Industry Considerations

• Look at the key success factors for the industry and think about how they may have changed. These changes should become more apparent as you reflect on the changes in all the other categories.
• Evaluate the elasticity of demand for the product or service. This is primarily a function of how essential a product or service is, but also depends on how competitive the market supply is and the availability of suitable substitute products and services.

Competitive Considerations

• Will the industry experience consolidation from some competitors closing? What will that mean for sales and for pricing?
• For those businesses whose sales were helped by the pandemic, will additional market entrants emerge? Again, what will that mean for sales and for pricing?
• Have any competitor’s responses to the pandemic resulted in a competitive advantage for that company? If so, will the evaluated business be able to replicate those advantages or develop other strategies to restore the competitive balance?
• What substitute products and services will emerge that were not previously a threat? For example, used car lots are going to have a difficult time competing against new car sales because of the low-interest or no-interest loans being offered along with extended loan periods.
• Will steep discounts be necessary to compete for sales? How steep will depend on what competitors are offering as well as general demand for the product or service.
• If discounting is necessary, how flexible is the cost structure? In other words, what degree of financial leverage exists? If fixed costs are high but variable costs are low with high profit margins, then lowering prices to increase volume will be beneficial. If profit margins are low, the flexibility to lower prices will be more limited.

Environmental Considerations

• If the business has made the commitment to environmentally-friendly practices like allowing re-use of shopping bags or encouraging customers to use their own, there may be additional costs because of the need to once again provide plastic or paper bags due to the pandemic.

International Considerations

• Because this pandemic is affecting the entire world, there are probably not a lot of additional considerations in this area but if critical personnel are required to travel in order to do their jobs, there may be some delays or additional costs to consider.

The next step is to evaluate how all these changes fit with the internal strengths and weaknesses of the subject company. Key areas to assess: 1) the adaptability/flexibility of management and the workforce in general, 2) technological prowess, 3) traditionally an early or late adopter of industry trends (or even an innovator), 4) reputation and marketing savvy, and 5) financial strength (reserve funds or access to capital, liquidity ratios, debt-to-equity ratio, breakeven sales, etc.) and risk management abilities. 

The general consensus among valuation professionals seems to be that discounted cash flow (DCF) is going to be the most appropriate method going forward for the majority of valuations, and that assumptions about the impacts will need to reflect multiple possible scenarios, each weighted subjectively as to the probability of occurrence, while keeping in mind the short-term will differ from the long-term (terminal value) scenarios. I would also advocate for the use of two different discount rates—one for the short-term and one for the long-term. Uncertainty drives risk, and there is much uncertainty in the current situation, and that additional risk is only partially offset by the lower interest rates.

Our job as valuators has just become much more complex. My intent in sharing this is to provide a structural framework for analysis. This is certainly not a comprehensive list of considerations; that will depend a great deal on the individual company and its industry, but hopefully, this will provide some guidance, provoke thought, and assist with justifying assumptions made in developing various cash flow scenarios.

---

Cathy Roper, CPA, ABV, CVA, CFE, CGMA, is an adjunct professor of accounting at Webster University, a long-time financial professional, and has the rare distinction of being an Elijah Watt Sells medalist when she sat for the CPA exam. Her firm, Roper Consulting Group, is based in St. Louis and specializes in business valuations, lost profits, economic damages, and other types of forensic accounting services. She also partners with ARA Fraud and Forensics in the prevention and detection of business fraud and the quantification of resulting damages.

Ms. Roper can be contacted at (314) 835-7876 or by e-mail to cathy.roper.cpa@roperconsultinggroup.com.