THE IMPACT OF THE COVID-19-CRISIS ON BUSINESS VALUATION
The extensive economic changes provoked by the COVID-19-crisis have led to some urgent questions regarding the business valuation. In order to offer guidance on how to consider these extraordinary circumstances properly when valuing a business, the German Committee on Business Valuation and Business Administration (FAUB, Germany) has published a professional statement on 27 March 2020 (“The Impact of the Coronavirus in Business Valuation”). However, since the statement is kept quite abstract and no specific instructions can be derived from this professional advice, the publication is only of limited use to practitioners. The present article constitutes a short overview of the many aspects that have to be taken into account when valuing a business under the COVID-19-crisis by applying the discounted cash flow model.
2. IMPACT ON INTERNAL FORECASTS
2.1 DETAILED PLANNING PHASE
According to the Austrian Professional Guidelines KFS/BW 1, Rz 24, in the process of business valuation one should consider “all significant information that could have been obtained with due care up to the valuation date”. Therefore, business plans within the detailed planning phase would need to be adapted accordingly, if the consequences of the COVID-19-crisis were already foreseeable on the valuation date. However, in practice most forecasts were not adjusted so far and do not reflect the severe changes in the sales and supply markets consequently. As the FAUB stated correctly, it is up to the appraiser whether to modify the business planning and the forecasts respectively.
2.1.1 THE UNCERTAINTY OF FUTURE CASH FLOWS
Many factors lead to a massive increase in planning uncertainty at the present. First, long-term health-implications cannot be evaluated orderly at the moment. Second, governments around the world found themselves forced to arrange significant economic restrictions in light of these health-related insecurities. Especially the shutdown of entire industries has affected the economy in a negative manner. Third, nobody can anticipate how long those restrictions will last.
In addition, as there is no precedent, one cannot just rely on experience and draw conclusions from the past. Correspondingly, the range of possible future cash flows is more volatile, as a large variety of scenarios seems possible. Not least because of the acute liquidity shortages and the accompanied increased risk of insolvency, an accurate forecast of future cash flows appears imbossible (Gleißner, forthcoming). The high risk of insolvency can also be seen in the growth of the credit spreads.[i]
Overall, we therefore recommend the intensified use of scenario calculations, the way they are proposed by KFS/BW 1, Rz 77. In this manner, the increased planning uncertainty can be depicted appropriately, and the full range of possible cash flows can be condensed into a single expected value.
2.1.2 GOVERNMENT MEASURES
Whilst the enormous economic impacts of the COVID-19-crisis affect the companies’ forecasts negatively, governments have taken legal and regulatory steps in order to engage in damage limitation. In Austria it is mostly the law on measures against COVID-19 (ie “COVID-19-Maßnahmengesetz”, Austria) and the thereby launched Corona-fund (commonly known as “Corona-Krisenfonds”, Austria) that has brought some financial relief for entrepreneurs. The state measures provided by the law mainly consist of financial subsidies and government-funded loans. Since those initiatives can be regarded beneficial to the companies and helpful when compensating for any negative economic effects, they need to be reflected in internal forecasts as well. As long as the requirements for state support can be met with sufficient probability, those government-measures have to be considered in scenario calculations even before a company got formal commitment. Any increased debt ratio as well as the market value of the debt capital or any kind of special repayment condition have to be taken into account when valuing a company.
2.2 PLANNING IN THE LONG VIEW
The effects of the COVID-19-crisis are not limited to the short view, long-term aspects have to be considered additionally. Even though the global development of the current situation cannot be anticipated accurately, it can be assumed that long-term negative effects on cash flows strongly depend on a company’s business model and thereby its robustness and resilience. In that view, we do share the FAUB’s opinion according to which valuation-related consequences may occur, if the COVID-19-crisis permanently changes the economic environment (eg with regard to the consumer behavior) and thus the whole business model needs to be amended. These long-term effects of the crisis are anticipated to differ significantly between industries. However, we believe that in the medium term the crisis can be overcome for most of the industries and possible long term effects on certain industries have to be analyzed case by case.
2.3 TERMINAL VALUE AND GROWTH RATE
Due to the current market situation, cash flows need to be adjusted in the detailed planning phase. Nonetheless, whether the crisis has to be considered in the terminal value strongly depends on the underlying business model and is therefore not that clear. This also applies to the growth rate within the terminal value. At the present, there are no hints indicating the requirement of adjusting the long-term valuation parameters when the underlying business model can be seen as robust. We believe that the initial growth rate – like for example the long-term inflation target of the European Central Bank (ECB)[ii] – can be maintained if the assumptions regarding expected returns, growth rates and reinvestment plans are consistent (Rabel, 2016).
3. IMPACT ON THE COST OF CAPITAL
The impact of the COVID-19-crisis on the cost of capital is not explicitly addressed within the FAUB’s professional advice. The committee only refers to the long-term orientation of the cost of capital and, thus, the crisis’ negligible importance for the cost of capital.
We can demonstrate, however, that current capital market data shows serious irregularities. It’s most of all the base interest rate, the implicit market return/the implicit market risk premium, the systematic risk (as measured by the beta factor) and the cost of debt that reflect these market irregularities. Despite the merely temporary character of these volatile times, a profound analysis of the current market situation is indispensable for exercising due care as required by KFS/BW 1, Rz 24.
3.1 NEGATIVE BASE INTEREST RATE
Since the base interest rate is usually seen as a proxy for the risk-free rate, it plays a crucial role in business valuation. In the context of the Capital Asset Pricing Model (CAPM) the base interest rate plays an important role in determining the cost of capital as well as the market risk premium. The rate is usually derived from the spot rate of a 30-year German Government Bond derived by Svensson/Siegel-formula.
To begin with, the low-interest environment has existed even before the COVID-19-crisis. By the mid of 2019, negative risk-free rates were already observable. However, after the interest situation has somewhat improved and interest rates turned positive again (at least temporarily), the COVID-19-crisis has triggered a renewed downward-trend. The spot rate of the 30-year German Government Bonds fell to an historical low of about –0.5024% (see the following figure).
Figure 1: trend of the 30-year spot rate of the German Government Bonds
After an initial panic reaction, share prices dropped from 24 February on (as illustrated by the red line in the figure) and the 30-year spot rate reached a temporary low of –0.5024% on 12 March. Afterwards, the spot rate recovered and rose again. On 6 April the sport rate of the 30-year German Government Bonds was about –0.0094 % – virtually 0 %. Therefore, it seems appropriate to us to renew our recommendation. In case of a negative base interest rate as of the reporting date, the interest rate should be limited to a minimum of > 0% (Bartl & Patloch-Kofler, 2019, p. 297f).
3.2 THE DEVELOPMENT OF THE IMPLICIT MARKET RETURN
Whilst the FAUB adheres to a long-term orientation when calculating the market risk premium and therefore negates the adjustment of the market risk premium in the light of the COVID-19-crisis,[i]
this approach cannot be adopted unchallenged in Austria. After all, the Austrian methodology of calculating the market risk premium differs to some extent from the German one. In accordance with KFS/BW 1, E 7, the market risk premium has to be derived on the reporting date and is calculated as the difference between the implicit market return and the base interest rate (Bartl & Gleißner, 2020).
Due to the effects of the COVID-19-crisis and the associated downward-trend in the stock markets, the development of the implicit market return shows tremendous irregularities from 24 February on, as you can see in the following figure 2.
Figure 2: implicit market returns
The figure above presents the daily market returns for the ATX Prime (AT), the CDAX (GE) and the STOXX Europe 600 (Europe) from 1 January 2020 till 6 April 2020, leaving all the other parameters unchanged (Aders, Aschauer, & Dollinger, 2016). Because of the heavy drop in the stock markets, the implicit market return rose from 24 February on, as represented by the STOXX Europe 600 for example.[ii] From an initial value of about 7.5 % on 24 February, the implicit market value increased constantly and reached a temporary peak on 17 March (9.4 %). This growth cannot be attributed to the economic environment only. Also, the way the implicit market return is calculated accounts at least partly for this development. After all, these extraordinary results may be impacted by a time lag of analysts in adopting future earnings consensus. As you can see in figure 2, the implicit market returns reached their initial values by the end of March due to the rebound of stock markets and the analysts’ readjustments of earnings expectations. The only exception consists in the implicit market return based on the ATX Prime as this index is impacted by a heavy weight in financial industry and oil & gas.
At the moment, the implicit market return of the STOXX Europe 600 amounts to 7.5 % (6 April 2020), whereas the rate is slightly higher for the CDAX (8.00 %) and for the ATX Prime, respectively (9.1 %). Since the risk-free rate is about 0 % currently, these implicit market returns simultaneously represent the market risk premia.
Figure 3: implicit market premia by 6.4.2020
Accordingly, there is no need for a mandatory increase in the implicit market return for valuation dates after March 2020 in our view. Rather, we would suggest choosing an implicit market return within the KFS/BW 1 E 7-framework. Nevertheless, a careful monitoring of further developments in light of the COVID-19-crisis is indispensable.
3.3 CHANGES IN THE SYSTEMATIC RISK
As a result of the synchronous drop of nearly all the stocks in the market, many beta factors changed abruptly. This observation requires a separate and sound analysis of all the data points in the regression model that constitutes the basis for calculating the beta factor. In particular, the total market’s volatility is quite high, as you can learn from the following figure 4.
Figure 4: development of the daily changes of the STOXX Europe 600
The question on how to deal with the COVID-19-crisis within the regression period can be considered a separate matter of research. In the meantime, we recommend the calculation of continuous beta factors over a longer period, in order to recognize and evaluate possible irregularities.
3.4 IRREGULARITIES IN THE CORPORATE BOND MARKET
As you can see in the following figures 5 and 6, the volatile character of the capital market parameters is also reflected in the credit spreads of corporate bonds.
Figure 5: return of corporate bonds, A-ratings
Figure 6: return of corporate bonds, B-ratings
In the period between 24 February and April 2020, a significant increase in European corporate bond yields is observable for any rating class. This rise has not reversed so far, so that the bond yields are still far from their initial level. Therefore, the higher credit spreads have to be taken into account when deriving the cost of debt, the WACC and the market value of the debt, respectively.
It seems evident that the COVID-19-crisis has some noticeable effects on businesses. Under these circumstances, appraisers need to question critically whether and how to consider those comprehensive changes in their business valuations properly. In this context, two major effects have to be distinguished. On the one hand, the COVID-19-crisis directly influences a company’s income situation whilst on the other hand, the crisis also leads to changes in the capital market parameters.
Since any impacts on the future income situation and the leverage ratio need to be evaluated on a firm-specific basis, no general conclusions can be drawn from it. The situation is different for the capital market parameters, however. Irregularities can be found in the base interest rate as well as in the implicit market rate and the returns from corporate bonds. While the base interest rate and the implicit market return have already reached their previous level again, the credit spreads are still higher compared to the prior period.
The analysis of the current capital market parameters doesn’t indicate mandatory adjustments of the implicit market return and the market risk premium for valuation dates after the stock crash on 24 February. For calculating the cost of debt and consequently the WACC as well as the market value of debt, the higher credit spreads resulting from the crisis have to be taken into account in business valuations, however.
It should be kept a critical eye on the capital market parameters, as further adjustments due to the COVID-19-crisis could become necessary. For this reason, we provide data for the cost of capital on a daily basis on bdo.at/kapitalmarktparameter.
Aders, C., Aschauer, E., & Dollinger, M. (2016). Die implizite Marktrisikoprämie am österreichischen Kapitalmarkt. RWZ (6).
Bartl, M., & Gleißner, W. (2020). Unternehmensbewertung: Marktrisikoprämie in Österreich. CFOaktuell (1).
Bartl, M., & Patloch-Kofler, M. (2019). Negativer Basiszins in der Unternehmensbewertung. RWZ, 29(5).
Gleißner, W. (forthcoming). Unternehmensbewertung in der „Corona-Krise“. CORPORATE FINANCE.
Rabel, K. (2016). Grobplanungsphase und Terminal Value nach dem Standard KFS/BW1. RWZ (9).
[i] More detailed in section 3.4.
[ii] The inflation target is frequently observed and confirmed by the European Commission and supported by the monetary policy of the ECB.
[iii] The FAUB recommends a market risk premium between 6.00 and 8.00 %. The last time the recommendation was raised on 25 October 2019.
[iv] For the general advantage of the STOXX Europe 600 for deriving the implicit market return, see Bartl and Gleißner (2020).