Business Valuation in the COVID-19 Recession

So how do you value a private business in New Zealand in these covid19 recession times? It’s not simple.

The process I suggest is to:

  • work out if your business truly is a going concern
  • forecast your earnings and balance sheet during and post-shutdown
  • analyse the risk of those future earnings in the coming years
  • look for recent market data
  • consider asset values
  • accept the uncertainty of the valuation but be clear about assumptions
  • and consider a staggered sale of equity.

Let’s go through these.

Going Concern: can the business survive?

This is simply about cash flow or solvency.

Do you have sufficient net cash flow in the business to be able withstand the covid19 recession? Can you free up cash by deferring expenses, collecting accounts receivable, or accessing government support? Do you have the funds to increase equity or convince a bank to provide a loan? Can you run a bare bones operation at breakeven?

I don’t mean the technical legal test of going concern and the insolvency rules in covid19 times but whether the company has the wherewithal to survive the covid19 recession.

If not then the business may not be a going concern. I’m afraid the business is worth the value of assets that you (or the liquidator) can get in a distressed market.

You may need to return to this test having gone through cash flow forecasting below.

Assuming it passes this test then we look at a key part of any appraised value—earnings.

Forecasting Earnings and Valuation

If you can survive then you’ll need to forecast the future maintainable earnings, that’s because two of the valuation approaches require earnings. Let’s go back to valuation first principles.

The Principle of Anticipation is where we value the current worth of future benefits of the business, and use the Income-based valuation methodologies.

The Principle of Substitution is where we value a business based on the cost of acquiring an equal substitute, and have the Market-based valuation methodologies.

These two require earnings to either discount for risk (Income) or compare to similar businesses (Market).

The Principle of Reproduction is where we value what it would cost to establish a similar business, and we use the Asset-based business valuation methodologies. Even here we may need earnings to calculate intangible value.

We need to forecast earnings or we can’t value a business that is a going concern.

Operating Net Cash Flow and EBITDA

Often EBITDA (or its sister for smaller businesses EBPITDA which includes proprietor’s wages) is sufficient for an appraisal of value because it is a sufficiently accurate reflection of Operating Net Cash Flow.

But in these difficult times calculating free cash flows is critical and EBITDA is not Operating Cash Flow because it assumes accrual accounting for revenue and expenses.

We’ll consider the Balance Sheet briefly below but you should forecast the financials probably using a full three statement model i.e. P&L, Balance Sheet and Cash Flow Statement. This also helps with scenario planning, discussed below.— Brent Beshore (@BrentBeshore) April 24, 2020

Image Above: Earnings Before ITDA…and COVID19.

What Future Earnings??

It’s hard to forecast business earnings, industry revenue and country GDP at the best of times. And this ain’t the best of times.
So the fall back is to be honest and give scenarios. You saw Treasury NZ do that with its Economic Scenarios Report on 13 April.

We need to do the same thing.  We value the business based on the most likely scenarios not the best or worst ones.

By the time you read this there will be a new forecast from Treasury (Budget 14 May 2020) and the banks will likewise have provided their forecasts too. You may have five forecasts like Treasury, a median forecast with the outliers being unlikely but possible. You certainly want the three more likely forecasts for your key financial drivers (often volume, price and gross margin %).

Every industry is different perhaps you can use the GDP, commodity, unemployment, sector or regional forecasts as drivers of your own business forecasts.

Scenario modelling is not part of this article but I’ll write about it in the future so perhaps check my Article home page.

You’ll need different earnings for different valuation methods. For instance Discounted Cash Flow (DCF) requires free cash flow, but the market method requires EBITDA, EBIT or EBPITDA.

Balance Sheet and Cash Flow Statement

As part of your modelling you’ll forecast changes in the Balance Sheet. Surely during these times, your customers are slow to pay, you may have reached arrangements to pay your suppliers more slowly, the government may be providing a wage subsidy or IRD loan, the bank may provide a loan or you may put more equity into the business. These changes in balance sheet items will then flow down into the cash flow statement.

You’ll also see how covid19 times has directly destroyed company value. Your cash balance will likely decrease and your liabilities increase. For example, in a share sale you’ll have less room for a dividend pre-settlement and in an asset sale you’ll be left with accounts receivable that include bad debt (see this article re share vs asset sale).

Valuation Date

If you look at the stockmarket you see daily changes in business valuation on a public basis as buyers and sellers rapidly incorporate the latest information into stock prices.

A private business does not have this daily pricing mechanism but the date of the valuation is still key, think of a business value on 31 December 2019 versus its value on 30 April 2020 in the middle of Level 4 lockdown.

This is why scenarios are required, we can give a valuation date but then proceed to give a valuation range as of that date given the future uncertainty.

So we’ve discussed the need to forecast the P&L, Balance Sheet and Cash Flow Statement on a specific date. Next we’ll apply those scenario forecasts.

Income Method

In theory a business is worth its discounted future cash flows. In practice this method is simply a check on the market transaction multiples (perhaps also casting a quick glance at public trading multiples for context) because of the difficulty and subjectiveness in forecasting earnings.

Those days have gone. Forecasting by month as the covid19 crisis unfolds is crucial as the near term earnings are likely poor. At some stage the economy will return perhaps to 90% of pre-covid times (The 90% Economy, subscription required), perhaps by 2021, and then 2-3 years out things may return to normal. We need to forecast this period because the lockdown is not a fair reflection of future cash flows but nor was the pre-covid19 boom times.

Cash Flow

So we don’t use the next 12 months as the earnings figure but rather we look at future cash flows over the coming years and model scenarios based on assumptions as discussed in the previous sections. This provides a sort of weighted average of the near term bad times and more normal future period.

Risk rate

We need to careful not to “double dip” with respect to cash flow and the risk rate. If we have adequately made allowance for reduced income in our cash flow forecasts we might not need to increase the discount rate as much.

There are various methods of estimating risk. For the purposes of this article I’ll use the build up method, see Capitalisation rates in my Business Valuation in New Zealand article.

Let’s assume:

  • a valuation date of 31 December 2019
  • a stable mid-market business (well stable until covid19 hit…)
  • risk free rate is 1%
  • equity risk premium is 5%
  • specific company risk premium is 15%
  • and there is long term growth rate of 1%.

The capitalisation rate is: 20% = 1 + 5 + 15 – 1 (illustrative only).

Now let’s assume a valuation date of 12 May 2020, and everything else remains the same except for the specific company risk premium which increases to 20%.

The capitalisation rate is now: 25% = 1 + 5 + 20 – 1 (illustrative only).

So we build in the increased risk by increasing the specific company risk premium.

Note DCF requires you to calculate WACC so you need to include any debt (this article is not about DCF but applying it in covid19 times).

Income Method Summary

The DCF model forecasts future cash flow probably by reducing earnings, increasing working capital, reducing the cash account, increasing long term debt, and reducing capital expenditure.

It then applies an increased discount rate to discount cash flows. The drop in valuation is therefore due to the reduction in net cash flow and the increase in the discount rate.

Market Method

For mid-market businesses, in a word, difficult.

Pre-covid19 recession mid-market multiples are no longer valid. The M&A market at the time of writing has seized up as everyone pauses to focus on their own business or portfolio companies, complete a previous transaction they cannot walk away from, and look for more certainty before committing to investment. As 2020 progresses we will start to see more transaction flow and use this method with more confidence. I expect it will show lower values but will watch with interest.

If there are truly similar businesses on the stock market then the percentage drop in their market valuation may be one indicator of the drop in the private business. Currently the drop in interest rates seems to be providing a floor in stock market values making this a difficult comparison.

On the other hand, small business multiples tend not to change much over time. If a small business has adequately changed its forecasts for the next 12 months then perhaps you just apply the normal multiple to the reduced forecast earnings. There is some correlation between lower earnings and lower multiples in small business sales so this will provide some self-correction.

Again scenarios are appropriate with a wider range of appraised values.

Asset Method

This is where you sum all asset values and is more prevalent with heavy equipment type businesses. You’d usually get an expert equipment valuer but the problem for them is the equipment market may also have seized up resulting in more uncertainty around equipment values. Try selling an aircraft right now for example…

You also need to value intangible assets where you apply the income method to earning streams like long term contracts or IP licenses. Future cash flow forecasting is difficult as described above as above.

Uncertainty vs Risk

For the purposes of valuation we should assume that uncertainty and risk are different things. Risk is the volatility you’d expect in an investment. Uncertainty is not being able to find relevant information in a market that has ceased up.

Covid19 has caused uncertainty. We need to go back to the scenarios and ignore the outliers and choose the three most likely scenarios, a sort of “one standard deviation” approach. Provide the assumptions behind the scenarios and leave the report reader to make their own assessment of what scenario is more likely.

Joint Venture?

If you still want to sell (or buy) equity in a private business and are naturally uncertain about value then a joint venture maybe your best option.

In essence, you would sell a part of the company and have a shareholders agreement that provides call/put options for further equity sales at specific times in the future. The valuation process would be agreed with an independent arbitrator clause if needs be.

Yes, a form of earn-out with all its problems—but if there was ever a time for earn-out this is it.


Forecast your cash flows over the coming few years by month using scenarios given the uncertainty. Use the DCF method to value those forecast income streams.

Check for any recent market business sales or acquisition data. If available apply these multiples. If you’re lucky enough to have a similar business trading on the stock market then analysis the percentage drop in their value.

The big change in an appraisal report is the use of scenarios to outline a wider range of value based on clear assumptions. Uncertainty means a narrow range of values is inappropriate.

Lastly, use an earn-out arrangement to protect business value or equity investment.