The NBA & NHL have suspended play.
MLB has postponed the start of its season.
Public & private schools around the country are closing.
Locally, the NYC St. Patricks’ Day parade and other large public gatherings are canceled, amongst the rumors surrounding that the city will order a mandatory quarantine.
These are just a few of the headlines we have heard and read this week in response to the current coronavirus pandemic.
The health of our family, friends, and neighbors is paramount at this time. Still, as the stock market seems to be in freefall, one can only wonder what impact the coronavirus will have on the short-term and long-term valuation of closely-held businesses.
The micro and macroeconomic communities have experienced this turmoil before. Of course, there was 911 and the financial crisis of 2008, but when was the last time the spokes on the economic wheel have slowed down or stopped because people were either too sick to work or discouraged from going to work? Yes, many of us will be able to work from home; but let’s be honest – it will not be the same.
Local restaurants and attractions expect to see a drastic decrease in business; the travel and hospitality business is flooded with cancellations, despite offering services at unheard-of low prices. (Someone told me you could fly to Florida this weekend for $50.)
If you are one of our frequent readers, you are familiar with the three general methods of valuation, the asset, market, and income approaches. The asset approach examines the net book value of the business at a given point in time. The market approach determines value by examining sale transactions of similar companies. As of today, the effects of these two approaches resulting from the coronavirus cannot be quantified. However, the income approach is primed to address the impact of the current pandemic.
Simply stated, the income approach considers three factors to determine value, cash flow, growth, and risk. Each of which may or perhaps will, be affected by current events.
Cash Flow
Cash flow is defined as the earnings stream the business expects to generate in perpetuity. Whether it is determined from historical or prospective anticipation, it is based on the analyst’s review of the subject’s operations. In some instances, these results may be adversely affected or expanded from the effects of the coronavirus. For example, the subject may become a manufacturer or supplier of a product or service that will be regularly used. Alternatively, individual businesses may be affected by a temporary or permanent loss of income.
Growth
Growth rates measure the expected growth rate applied to subjects’ cash flow. It is intended to include the sum of both inflation and real growth. Growth is significant to a hypothetical investor/buyer since it often used to quantify their future expectations. A pandemic like a coronavirus may have both short-term and long-term growth affects – particularly if it initiates an economic recession.
Risk
Even under normal conditions, the evaluation of the subjects’ risk is often a critical part of the valuation analysis. Risk has a direct effect on the valuation multiple. The higher the risk, the lower the valuation multiple used in the income approach.
Risk is an expression of the analyst’s judgment as no empirical evidence or database exists, or can exist, to measure the company-specific risk drivers. The analyst must identify material, specific company risk drivers, and judge their magnitude to estimate the additional incremental rate of return the market would require to offset the acceptance by the investor of that additional risk. The factors and extent which comprise this component will vary from company to company, among industries, and over time within the same company. Before the coronavirus pandemic, we generally considered the depth of management, the importance of key personnel, the stability of the industry, diversification of product or service, diversification of vendors, geographic location, and earnings margins to be these main risk drivers. Now we have to also consider the effects of the business due to the coronavirus.
Conclusion
As of today, it may be too soon to say what the long-term effect the coronavirus will have on our economy or the valuation of closely-held businesses. What we do know is that investor confidence, consumer consumption, and the civic/municipality response have yet to be fully determined. In other words, we just have to wait and see. The immediate issue may be how closely-held businesses can marshall their current resources to support themselves in the short-term.