The market-based approach to valuation is changing. In these unusual times, it may be no longer representative to look at prior periods’ financial performance and profit generation alone to forecast a company’s future earnings.
A more focused holistic view of a company is needed. An in-depth review of the markets in which the company operates, its customers, its business model, security of income and ultimately, the quality of its earnings need to be assessed.
We at PEM Corporate Finance have always used ‘Value Drivers’ as part of our valuation assessments. These are often qualitative characteristics of a business which affect the value of the business positively or negatively and the ‘Value Drivers’ help us assess a company’s sustainable earnings figure to apply this multiple to.
Value drivers may be derived from questions such as:
It would be difficult to reliably value a business based off value drivers alone. The value drivers need to be used in parallel with a market-based approach.
The qualitative characteristics of the company need to be better understood to generate a more comparable bucket of transactions and companies rather than just looking at companies in the same sector etc. This approach, in theory, will result in a more applicable multiple.
Other factors to consider when using comparable company metrics should include whether the financial data is historical or not. This historical data may not have factored the COVID-19 impact on the business and therefore may be unrepresentative.
The International Private Equity and Venture Capital (IPEV) Board helpfully produced special valuation guidelines for valuing private companies in COVID-19. Following these guidelines, if the financial data is historical one can use the percentage change in market capitalisation of comparable public companies as this may provide a good proxy for the magnitude of the change to be expected in the multiple.
IPEV also state that care should be taken not to “double dip” with respect to valuation inputs—if performance metrics have been adjusted to take into account lower expected performance, an appropriate multiple should be applied rather than a multiple derived from comparable public companies whose results have not yet included lower expected performance.
In any case revenue and earnings metrics must be evaluated in the context of market participant perspectives. Generally, market participants focus on maintainable earnings or maintainable revenue. Therefore, one-time impacts would be excluded from the metric to which the multiple is applied.
Professional judgement is needed to analyse what really is a one-time impact to the business. Quantifying the COVID-19 impact to earnings is useful but if that impact will cause continuing and long-term impacts to earnings then it shouldn’t be adjusted for.
Further consideration is needed when calculating equity value. Calculating a level of surplus cash using a working capital calculation that is retrospective may not be prudent. Many businesses have taken advantage of payment holidays, be it from HMRC or others, stretched creditors days and tried to shortened debtor days, all of which will skew the net working capital figure.
For those businesses with higher levels of gearing, liquidity needs to be evaluated. If the impact of COVID-19 has negatively impacted earnings, what is the likelihood of the company breaching debt covenants? What is the impact of extended reduced cashflow?
In summary, when using the market-based approach one needs to;
The above are just some of the factors of consideration to keep in mind when valuing private companies.