Over the past couple months, we have seen many businesses and industries adjust to the unprecedented environment that COVID-19 has created. As an advisor to companies on both sides of M&A transactions, Larx has needed to adjust how we calculate a business’ valuation. During these uncertain times, many business valuation assumptions have changed, and some have even become more of a variable than a constant.
Discounted Cash Flow (DCF) will be the focal point of this blog, however it is worth noting that other valuation methods have been affected by the pandemic as well. Within a DCF, there are six factors within a company’s cash flow and valuation that have likely changed during the pandemic and require a closer examination:
- Quality of Revenue/Sales:
- It is not just the quantity of sales, but also the quality that matters for a company during these times. Companies need to understand if their sales/revenue are recurring or non-recurring, and how much of each. Furthermore, understanding their customer churn rate and the barriers to switching can help a business determine how much their revenue, and therefore cash flow, will fluctuate during and after the pandemic.
- Customer’s Financial/Operational Exposure:
- Diving deeper into our customer analysis, we must think about the customer’s financial and operational exposure to COVID-19. Especially in a B2B setting it is important to consider your customer’s finances (i.e. working capital, cash flow, etc.) and how their supply chains may be affected.
- Sales Channel Mix:
- From a historical perspective, we look at how many sales have come through online channels compared to more analog channels. As for sales projections in a COVID world, we must consider the significant reduction of in-person sales and an increase in online sales, as we have seen from retailers large and small. We must evaluate whether and to what extent sales can move online, and how distribution will be handled. These are changes that can have a significant impact to both the top and bottom line.
- Working Capital:
- Cash on hand and burn rate can be a matter of life or death for a company during these uncertain times. As revenues are anything but certain right now, companies must be prepared to weather some potential negative months. During recessionary times, there are advantages to substantial cash other than survival. This can be a significant growth opportunity for a firm that is well positioned with the proper capital. This could be a time for a company to expand their operations, greatly improving future cash flows.
- A quick injection of capital can come from multiple sources, however with interest rates as low as they are, debt is a quick solution to liquidity for those who can get it. In operations, the company will need to have an honest evaluation of their debt, including the likelihood of default, their interest payment coverage for both the short- and long-term, and the value of their collateral during and after COVID.
- Discount Rate:
- At the heart of any DCF is the discount rate, which allows us to find the present value of our projected future cash flows. As the Fed has lowered rates, the baseline “risk-free” rate has dropped with it. The market risk premium has greatly fluctuated this year, as visualized through the US equity markets. When shutdowns first occurred, the markets plummeted at their fastest rate ever, signaling a large spike in investor risk premium. However, in the subsequent months, the market has rallied back to all-time highs showing a pursuit for greater yields and the influence of the asset purchasing activities of the Fed and their recent laissez-faire approach to inflation. Beta is likely the most difficult to determine as each industry has reacted differently to the COVID economy. With the current market volatility, beta may in fact not change at all due to its relativistic association to the market.
These six areas are not the only ones to change during the pandemic, however they are worth noting for their influence and potential variability within the company and its valuation. One area not mentioned above that has and could greatly affect businesses is governmental interventions. As of this writing, there are currently a couple of loan products for struggling companies such as the SBA Emergency Injury Disaster Loan (EIDL) program and the Payroll Protection Program (PPP). There are benefits to both that could help a company navigate these waters. From a valuation point of view, the use of these government benefits will adjust past cash flows, and any future programs are difficult, if not impossible, to predict in the model.