How To Protect Your Company’s Value In 2020
The extent of the economic impact of coronavirus is largely unknown at this point, but its detrimental effects on both the economy and our lives are clear. This can be evidenced by looking outside and talking to those close to us.
Families are facing both emotional and economic hardship, businesses are closing (either temporarily or permanently), laid-off workers are seeking employment, and countless frontline workers are putting their lives at stake every day to ensure and protect the health and general wellbeing of the public. No matter who you are, we are all feeling the effects of this pandemic.
In particular, as a business owner, you are being presented with many tough decisions during this time, balancing the needs of your employees, customers, and yourself. For most business owners, your business comprises a significant portion of your accumulated wealth, begging the question, “How will the current state of the economy and its aftereffects impact the value of my business?” This is a difficult question to answer because of the company-specific variables involved and the uncertainties surrounding the pandemic.
Read on for some timely insights and a toolkit of considerations regarding the value of your business during these uncertain times.
Check out our webinar series, “Shifting The Business Infrastructure,” for more insight into how to manage your business during the COVID-19 crisis.
Getting Back To The Basics
To understand how the COVID-19 pandemic will affect the value of your business, you should first obtain a better understanding of the fundamentals of business valuation.
When valuing a closely held business, a valuation expert will typically consider three different valuation approaches: an income, market, and asset approach.
The Income Approach
The income approach determines the value of the future economic benefit an investor would receive from owning an asset. To determine this value, an investor needs to know
- The future cash flow of the business; and
- The required rate of return to invest in the business.
The required rate of return is largely based on the amount of risk present in receiving the expected future cash flows, and it has an inverse relationship with the value of your business. Therefore, the higher the required rate of return, the lower the value of the business.
In these times of uncertainty caused by the pandemic, the risk for investors has increased, and therefore, their required rate of return has also increased, driving down the value of many businesses. However, the extent of the impact is largely specific to your business and its corresponding industry.
In these times of uncertainty caused by the pandemic, the risk for investors has increased, and therefore, their required rate of return has also increased, driving down the value of many businesses. However, the extent of the impact is largely specific to your business and its corresponding industry.
The Market Approach
Under the market approach, we look for guidance from similar companies, often referred to as “guideline companies,” that have been sold. To determine the value of a business, we need to apply a multiple to a selected financial metric, often earnings before interest, tax, depreciation, and amortization (“EBITDA”), using the guideline companies in order to arrive at the value of a business. In today’s environment, this approach poses certain problems in valuing a business.
First, when we are selecting guideline companies, we are using historical data that likely does not accurately represent current economic conditions. Second, because it is largely unknown for many businesses what their EBITDA will be in the future, a business’ historical EBITDA may not be an appropriate indication of the future. As a result, there is an increased risk for an investor, causing multiples to dip in order to compensate investors for taking on this additional risk in our current environment.
The Asset Approach
The income and market approach are utilized when determining the value of an operating entity of growing concern. The asset approach is typically only used as the determinant of value when the liquidation value of a business is greater than the value of the operating business determined under the income and market approach. In essence, this would imply an owner would receive a greater return on their investment by liquidating the business’ assets, paying off all liabilities, and ceasing operations, rather than continuing its normal operations.
The asset approach does not account for or consider any intangible value, such as goodwill.
Estimating future earnings is vital for both the income and market approach. The coronavirus pandemic increases the difficulty of estimating future earnings due to the added uncertainty in the overall economy. In addition, an inherent weakness of the market approach is that it assumes one level of earnings for a business. For example, using your business’ historical EBITDA may not be appropriate to use in a valuation today because it is not indicative of the foreseeable future. At the same time, using a forecast of 2020 EBITDA may not be appropriate either, as you may expect your business to recover in a matter of time. For this reason, the income approach is best captures the value of most businesses today, because it can incorporate changes in the future profitability of a business.
Listen to episode 240, “How To Tackle Your Business’s Cash Flow & Cost Optimization In The Era Of COVID-19,” on Rea & Associates’ award-winning podcast, unsuitable on Rea Radio.
The Macroeconomic Backdrop
Statistics such as GDP growth, consumer spending, personal income, and unemployment rates can help us gauge how much business activity as a whole may be impacted by the pandemic.
According to the Bureau of Economic Analysis, GDP declined by 5 percent in the first quarter of 2020 and by 32.9 percent in the second quarter of 2020. A recession is often formally recognized as a decline in GDP over two consecutive quarters. Based on the statistics outlined and following this definition, we are currently enduring a possibly severe recession.
Unemployment is another common indicator used to gauge the strength of the economy. The May report from the Bureau of Labor Statistics measured the unemployment rate at 14.7 percent. Since then, the unemployment rate has declined to 11.1 percent as of June. Despite this, the unemployment rate is higher than it has been during any other time since the government began tracking the data in 1948; although the unemployment rate was higher during the Great Depression, during which it was estimated to have peaked around 25 percent.
To illustrate how quickly the economic shut down has caused people to lose jobs, we can examine initial unemployment claims. Initial claims peaked at 6.9 million during the last week of March and have been steadily declining since. The week ending July 4, initial claims were 1.3 million. To put the number of initial claims into perspective, during the Great Recession it took roughly two years for 8.6 million Americans to file for unemployment.
It is clear that we are in unprecedented times as it relates to the number of unemployed and the speed at which people have lost jobs.
On a positive note, as states continue to reopen, it is expected that the unemployment rate will continue to decline since 10.6 million people have been labeled as temporally unemployed. However, it is unlikely that the U.S. will return to its historically low pre-pandemic unemployment rate of 3.5 percent.
The turmoil in the economy can be seen by the performance of public stock markets during the past couple of months.
The stock market is a leading indicator, meaning a downward movement in the market will typically precede a recession. Using the S&P 500 as a proxy for the overall stock market, in 2020 the S&P 500 peaked on Feb. 19, and subsequently hit a low on March 23, dropping about 34 percent during this period. As of the end of Aug. 3, it has mostly recovered from this low in March, increasing by about 40 percent, but still down roughly 3 percent from its peak in February.
Fluctuations in public markets are not necessarily an indication of movement in the value of private businesses. However, there are certain similarities that we expect to see as the effects of the coronavirus materialize. Preceding a recession, investors will typically see the price to earnings multiples lower in anticipation of lower future earnings. In private markets, while information is not as readily available as public markets, we expect to see a similar trend in price to EBITDA multiples as transaction data for private companies is released over the coming months.
Check out Rea’s COVID-19 Resource Center For Employers.
What Does a Recovery Look Like?
The first scenario would be a “U” shaped recovery. The economy would re-open slowly and the unemployment level would remain elevated for some time as people have to search for new jobs. It would take a prolonged period for the economy to be back at full strength.
The second scenario is a “W” shaped recovery. In this scenario, the economy would reopen once the virus begins to die down. As people return to work, the virus would begin to spread rapidly causing the resurgence of stay-at-home orders shutting the economy down again. This could happen several times until a vaccine is released. The economy would start and stop until a vaccine is released.
Based on the information we know today, it appears that a “W” shaped recovery is most likely.
As states reopen we have seen a significant increase in the number of COVID-19 cases. As a result, several states have begun to implement restrictions again, such as closing indoor dining areas, bars, and public beaches. In any scenario, it is likely that life will not be able to return to “normal” until a vaccine is released. Current estimates for a vaccine indicate a 2021 release to the public.
This implies that many businesses will have significantly reduced earnings potential for likely several quarters. The severity of the reduction will depend entirely on the business and industry. For example, many retail outlets will see massive reductions in revenues, while construction may see minimal impact since construction companies have been able to continue to operate similarly to pre-pandemic times.
Check Out This Free Webinar: “What Is Life After Coronavirus? Impact On Business Valuations & Opportunities For Succession Planning.”
Key Takeaways: How to Assess Value Impact
In assessing the value of your business, it is important to consider the following questions:
- To what extent has the coronavirus impacted my business’ sales and profits?
- Are the impacts on my business going to be temporary or permanent?
- How long will it take for my business to recover?
- Will business return to pre-pandemic levels, or will there be a “new normal”?
- What impact does the coronavirus have on my customer base?
- How is the competitive environment of my business changing during this pandemic?
- How can I best position my business to be successful following this pandemic?
It is important to keep in mind that when valuing any business, it is largely measuring the future economic benefit to an investor. How your business has performed historically is insignificant if it is not indicative of the future. For this reason, the value impact of the coronavirus will be different for every business and will heavily rely upon the answers to the questions listed above.
While the pandemic has challenged many aspects of our daily lives, it does present an opportunity for those wishing to gift their business or for those who may be managing the estate of someone who recently passed away. By gifting all or a portion of your business today or choosing an alternative date for an estate tax filing, you may be able to reduce the tax liability due to lower valuation levels caused by the coronavirus pandemic.
If you have any questions or if we can act as a resource for you and your business during this time of uncertainty, please contact Rea & Associates today.
By Jack Miklos, valuation and transaction advisory services (Dublin office)
Looking for more business valuation and transaction advisory tips and insight? Check out these resources.
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