How to value your business during COVID times?

Valuation under Income Approach and its preference during COVID-19 times

The income approach of business valuation is based on the idea of valuing the present value of future benefits. This approach estimates business value by considering the future income accruing over a period of time. There are two major methods that fall under this category which is capitalisation of earning method and discounted cash flow method.

A valuer should consider the subject company's cash balance and cash usage rate in assessing the company's ability to continue operations. This also includes assessing changes the company has made to preserve capital during this time period as well as going forward. Doing so will give the valuer a good idea of how long the company may survive under the current situation.

Why is Income Approach Valuation methodology more appropriate during the COVID-19 pandemic?

The Income approach is emphasized to value business in the new COVID-19 age with the use of multiple projection scenario analyses and probability-weighted outcomes. The key in DCF analysis, one of the methods under Income Approach, is the development of projections that reflect COVID19-related impacts including a subsequent recovery to a point of stability and maturity over the long term. Forecasting and computation of discount rate under DCF analysis require significant judgement on the part of the valuer in tandem with management perspectives as to the company's long-term outlook. The cash flow projection rationales must be fully documented and shall include the effect of all relevant economic, industry, and company specific factors, as affected by COVID-19, and as known or knowable as of the valuation date. Also, the DCF method may be more suitable to estimate the limited and short-lived downside period more accurately as compared to other valuation methods.

Also, a H-model or multi-period model may be used with multiple discount rates to factor the expected short-term and long-term risks of the company. A higher discount rate may be applied for the first 3-year period when COVID-19 is expected to impact the earnings of the company comparatively more than the next 2 years for which a lower discount rate may be selected and for the period after which the business activity returns to normal, a terminal discount rate may be used which is in conjunction with the long-term Cost of equity of the company.

With the recent uncertainty created by the COVID-19 pandemic, the use of the Discounted Cash Flow analysis may be more appropriate for the determination of fair market value for many small closely held businesses such as private limited companies or unlisted public companies.

Aspects to be considered during valuation under Income Approach due to COVID-19

1) Cash Flow projections and adjustments

Business valuation involves making cash flow projections and is forward-looking in nature and such cash flow projections reflect what is "known or knowable" to the valuer on the measurement date i.e the valuation date. Due to the rapid, material and sudden change in the economy and the industry around the world, the valuation of a particular entity may be drastically different as on 31st December 2019 as compared to the valuation of the same entity carried out on 31st March, 2020 or on 31st March, 2021. Since there shall be significant fluctuations and variances from historical trends of revenue and expenses across financial years 2020, 2021 and 2022, the requirement of making normalization adjustments to such revenue and expenses becomes of paramount importance during forecasting of financial statements for the purpose of valuation.

The materiality of such cash flow adjustments may vary depending on the specific entity type. Furthermore, there is significant uncertainty about the duration and frequency of pandemic outbreaks, requiring substantial judgement and scepticism on the part of the valuer in development of cash flow projections based on the "known and the knowable" at the time of the valuation.

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