M&A and valuations in COVID-19 times
The COVID-19 pandemic has major implications both in terms of operational and of financial management. Having spent the last few weeks focusing on establishing effective crisis management systems and securing liquidity, companies have increasingly returned to looking at the medium and long-term effects of the crisis and preparing for the “new normal”.
For many companies, questions of valuation are gaining in importance again. In the context of IFRS accounting, the COVID-19 crisis may constitute a triggering event that requires testing intangible assets or goodwill for impairment. At the same time, thoughts regarding possible M&A transactions come back into focus. Over the coming months it would seem likely that there will be opportunities to acquire companies at attractive valuations. Given good liquidity levels and high debt capacities, there should also be opportunities for public takeovers.
But how should companies be valued specifically in times of COVID-19? An initial estimate can be obtained by comparing the share price performance (measured as total shareholder return, TSR) of a global sample of companies with analysts’ EBITDA forecasts for 2020. Two basic patterns can be identified in this regard.
Median TSR and change in EBITDA forecasts since early 2020
Data: Bloomberg (19 May 2020).
In the case of companies whose share prices have declined to a noticeably lesser extent than the EBITDA forecast, the share of future growth value (FGV) in the market value has increased significantly. Consequently, market participants will assume that the weak operating result expected for the 2020 financial year will not continue in the future and that performance is likely to improve relatively quickly after the crisis is over. That pattern is emerging, for instance, in the Travel & Entertainment, Professional Services or MedTech sectors. Given that the share prices of these companies have outperformed their underlying operating performance, appropriate caution is required when acquiring such companies. It is important to determine whether the sometimes considerable decline in operating performance is really only attributable to a temporary, “government-imposed recession” or on the long-term impairment of the business model.
In some sectors, the market valuation has fallen much more sharply in recent months compared to the respective EBITDA forecasts for 2020. This development can be seen, inter alia, in the TMT, Software or Real Estate sectors. Based on the time before the COVID-19 crisis, these shares are therefore valued favourably and an acquisition of companies in these sectors might be worthwhile.
However, an analysis of the share price is an insufficient basis on which to form a well-founded opinion on the value of a company. Instead, this requires a valuation using the discounted cash flow method with detailed scenario and sensitivity analyses, taking into account the business model of the company.
When using the discounted cash flow method in times of great uncertainty, the following aspects must be considered in particular.
- The great uncertainty in developing a business plan relates both to the amount and the expected timing of future cash flows. In “normal times” such planning is often based on the historical development supplemented by the expectation of continued future improvements. In times of crisis, however, historical development is often a poor starting point for an accurate estimate of future development. A business case in times of great uncertainty must be based primarily on the expected development of the market, changes in the value chain and implications for the business model. It is important for this outside-in perspective to be systematically implemented for individual scenarios.
- In order to value business cases or scenarios, it is necessary to identify the main drivers of value and risk and to quantify their impact on value of the company by carrying out sensitivity analyses.
- In addition, due to uncertainties regarding the intensity and duration of the crisis, it may be useful to extend the usual detailed planning period in order to be able to map the return to a sustainable level (new normal) in detail.
- Risks arising from uncertainties in connection with the future development of the company must be taken into account in the valuation by considering various cash flow scenarios and probability-weighted cash flow forecasts and not by applying general risk premiums in the cost of capital.
- In the context of M&A transactions it may also be expedient to adjust or normalise the financial figures currently affected by the crisis. The EBITDAC (earnings before interest, tax, depreciation, amortization and coronavirus), for instance, allows a better understanding of a company’s long-term profitability.
Please do not hesitate to contact us with your valuation questions in these turbulent times.