With the COVID-19 pandemic mostly behind us, it is no exaggeration to say the impact has been immeasurable across all areas of life. Not escaping this phenomenon is the field of business valuation. With the practically overnight shutdown of the world in March 2020, few could have foreseen the changes in store.
Valuing Privately Held Businesses
The fundamental concept in valuing a privately held business is determining the current value of its future cash flows. All methods employed within a valuation engagement seek to incorporate this concept, albeit in various ways.
The income approach to value is generally considered the most useful method available. The American Institute of Certified Public Accountants (AICPA) defines the income approach as “a general way of determining a value indication of an asset, business or investment using one or more methods that convert expected economic benefits into a single amount.” The primary methods within the income approach are the discounted cash flow method and the capitalization of earnings method.
1. Discounted Cash Flow Method
The discounted cash flow method converts future expected net cash flows to a present value using a discount rate. While there are established methods for calculating the discount rate, the determination of future cash flows requires a knowledgeable company representative producing a future projection for 1-, 3- or 5- years. For a privately held business, this can be difficult. Add in the uncertainty of the pandemic, and reliable projections may be downright impossible.
2. Capitalization of Earnings Method
In a similar vein, the capitalization of earnings method is a method whereby the expected cash flows for a single representative period are converted to a present value through division by a capitalization rate (discount rate less growth rate). Rather than relying upon business projections, this method generally uses historical financial information to project the future cash flows. Typically, the capitalization of earnings method is only appropriate when the results of a business are not expected to change materially in the future, i.e., the company has stabilized operations.
The Pandemic’s Impact on Business Valuation
As can be assumed, the pandemic made incorporating either method under the income approach difficult. In our experience over these past two years, most businesses have encountered one of two vastly different outcomes due to the pandemic. Some companies have experienced record results given the strong demand for their products and services and increased pricing power. On the flip side, many businesses have struggled with increases in costs and lower demand for products and services. They have, therefore, become reliant on government financing intervention (i.e., Paycheck Protection Program, Employee Retention Credit, etc.).
Regardless of which group a business is in, most business owners realize these outlier results cannot last forever. Eventually, a reversion back to “normal” results is expected.
That leaves the valuation analyst in a tough position. How can future projections or a standalone period result be relied upon with such uncertainty? Unfortunately for our profession, there is no easy answer to this. A deep understanding of the revenues and associated input costs is required to utilize an income approach valuation method. This can only be reached via in-depth discussions with the management team to understand the ebbs and flows of the key drivers of the businesses’ operations.
Given the greater than normal uncertainty in determining the expected benefit stream in either income approach valuation method, the second primary variable of the income approach needs to be given a lot of thought. This variable is the discount rate, which is based on the amount of risk perceived in the expected benefit stream. In general, the more uncertainty there is regarding a business’s cash flows, the greater the risk.
The determination of the appropriate discount rate to apply to the cash flows is a valuation analyst’s variable to fine-tune the value conclusion of the income approach. Some of our common considerations over the past couple of years for this variable have been supply constraints, hiring difficulties and uncertainty of customer commitments.
Given the current level of disruption in the world, we recommend working with an experienced firm for your business valuation needs. Lutz M&A has an experienced group of analysts that can help. If you have any questions or would like to learn more, please contact us.
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