StraightTalk Webinar Series—March 2021

COVID-19 and Business Valuation—One Year Later: What Worked and What Didn’t

On March 2, 2021, Jim Hitchner, Managing Member of Valuation Products and Services (VPS), made a follow-up presentation, COVID-19 and Business Valuation—One Year Later: What Worked and What Didn’t. This article summarizes the issues discussed during this follow-up webinar.

A year has passed since the COVID-19 pandemic first impacted businesses. Business valuation (BV) practitioners preparing COVID-19 reports have grappled with how to incorporate the impact of this pandemic on the various industries and valuation reports. In this webinar, COVID-19 and Business Valuation—One Year Later: What Worked and What Didn’t, Jim Hitchner reassessed the predictions made. In addition, he (1) took a fresh look at the guideline company transaction method, (2) reviewed the challenges of using public market data, (3) explained why going concern values can be less than the net asset value, (4) reviewed the discounts for lack of marketability and control, (5) described what report writing changes should be made for COVID-19 valuation, and (6) discussed the impact of COVID-19 on BV standards.

COVID-19 and Business Valuation: Known and Knowable

A consensus has emerged regarding what was known and knowable. There is less debate here. Although the first U.S. cases were confirmed January 21, 2020, and WHO declared the coronavirus a Public Emergency of International Concern by mid-February 2020, Apple warned investors that the company did not expect to meet revenue guidance for the upcoming March 2020 quarter due the impact of COVID-19. As confirmed cases grew in the U.S. and Europe, it is clear that these events marked a turn and the condition was not hypothetical. The subsequent events, such as Florida and then New York declaring a state of emergency, are responses to a known event.

How to Apply Probability Scenarios

There still is some debate on how to weigh past years, particularly the results of 2020. The issue is whether the weightings are symmetrical or asymmetrical; assigning the same weight to the best case and worse case does not change the middle case weighting. BV analysts will need to understand the industry and justify the weightings. Asymmetrical weightings should be considered.

In the process of developing the discount rate, it is important to recognize that the COVID-19 discount rate should not be lower that the pre-COVID-19 discount rate, notwithstanding that the risk-free rate pre- and post-COVID-19 differed materially. The COVID-19 risk-free rate was significantly lower, but for many industries the company-specific risk premium more than offset the prior rate differential. The company-specific risk is viewed by most practitioners as the greater equalizer in this pandemic.

With regard to interim and long-term growth rates, BV practitioners will need to document the underlying basis for their assumptions. What sources should one consult? Consider the U.S. BEA and looking at GDP national, regional, state, MSA, county and industry forecasts. The consensus is that this part of the reports will take more time and effort.

A Fresh Look at the Guideline Company Transactions Method

In 2019, there were 2,396 transactions. In 2020, there were 937 transactions, with 459—almost half—occurring during the first quarter. Practitioners need to be careful using this method. In the presentation, transactional data was pulled from the restaurant industry. While the data for market cap appears to suggest that the worst is over for this industry, the trailing and forward P/Es are frothy for many entities, and that suggests one think twice about the reliability of using this underlying data for this industry.

The Going Concern Value Can Be Less than the Net Asset Value

Here, again, BV practitioners need to exercise caution. The new premise of value levels that have emerged include: (1) going concern value (assets fully funded); (2) going concern value (assets not fully funded); (3) orderly liquidation value; and (4) forced liquidation value. The latter two are commonly seen; it is the first two that mark a change on how companies may be valued. The going concern can be less than the net asset value on account that practitioners will develop a fair market value in continued use with assumed earnings vis-à-vis a fair market value in continued use with an earnings analysis (earnings supported by the business).

Discounts for Lack of Marketability

There is still controversy here. Minority interests remain hard to sell. The unresolved question is whether COVID-19 has exacerbated this problem. The other question is whether the DLOM applies to a control interest. Stated otherwise, should the value be lower if you cannot sell the business? If so, how does one compute that DLOM? The methods used to determine a DLOM of a 100% controlling interest include the Finnerty Arithmetic Strike Option and Ghaidarov Adjusted Arithmetic Average Strike Option DLOM. These are methods that Jim Hitchner said should be considered when assessing whether to apply the DLOM to a control interest. This assumes you believe in a DLOM for a 100% control interest, which Hitchner does not.

As for control premiums, Hitchner was not a believer in control premium before COVID-19 … and still is not. The problem here is that some investors will buy public companies whose stock value has significantly decreased, and when a control premium is calculated, the result is huge and not necessarily applicable for closely held companies. Again, one needs to proceed with caution, recognize that the capital structure matters, and if used, document the basis of any such premium.

Report Writing

COVID-19 should be in the economic, industry, and financial sections of the valuation report.

Conclusion

Jim Hitchner’s webinar provides mid-level and new practitioners an opportunity to hear from a seasoned professional what they should consider and be thinking about as they prepare reports. The addition to other data here, two prior issues of Financial Valuation and Litigation Expert (FVLE) (issues 85 and 86) provide valuable guidance and perspective. In short, Hitchner shares information to make us better valuation professionals.

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Roberto H Castro, JD, MBA, MST, CVA, is Managing Member of the Law Office of Roberto H Castro, PLLC and Legal Compliance counsel for Equilus Capital Partners, LLC, a closely held REIT. He is also Technical Editor of QuickRead and a member of NACVA’s CUV team.

Mr. Castro can be contacted at (509) 679-3668 or by e-mail to rcastro@rcastrolaw.com.