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The mantra that valuations are an art more than a science has never been more true as a result of the impact Covid 19 has had on businesses, but should buyers be trying to use more science to assist them in making valuation decisions?
Purism v practicalities
A share is worth the current value of its future income streams, being sum of the excess cash generated by the business plus the exit or terminal value of the share. This is the income approach and is the purist form of valuation. However in practise determining both the cashflows and the discount factor to apply to those cashflows is a complex, expense and timely process, out of reach for most buyers acquiring SME companies.
In practise the norm is for a buyer to consider the past earnings and apply a multiple to those earnings based on the market’s perceptions of the risk to and growth of those earnings in the future. The market approach is relatively easily undertaken, well understood, but very hard to truly justify a multiple.
The issue of systemic risk
The (market approach) methodology is to compare the business being valued to transactional data, either reported transactions in the recent past or data from listed companies.
The valuer must then use their experience to adjust this data for the myriad of factors that differentiate the business being valued to the comparator. These include issues of control, liquidity, systemic risk to the industry and non-systemic risk of the individual business.
The issue of systemic risk has been bought sharply into focus with Covid-19 but it is non-systemic risk in small companies that is often overlooked in valuations.
An investor investing in a listed entity has two significant advantages over an owner of shares in a small and medium sized enterprise. Firstly they can diversify their risk by making a portfolio of investments in other companies across different sectors. Secondly the listed company will have the size to diversify their business risk in key areas particularly management, staff, sectors, customers and suppliers.
Valuations in the present – a need to look ahead
How does this impact valuations at present? A valuer’s reliance on historic earnings to assess value now requires even greater analysis to understand the risks to those earnings and the impact of Covid-19 on those earnings in the short to medium term. Greater emphasis should be placed on looking at the future to assess the risks to those cashflows and how management will adapt to market shocks.
This has the benefit of generating better valuations for both income and market approaches, and also force management to consider the risks and how the business can be adapted to diversify the risk and ultimately create shareholder value.
As a result a buyer’s due diligence process must still analyse the past, but also encompass the future by building financial projections to assess value. Achieving this by looking at the risks inherent in the income streams and sensitising those projections to understand the impact of those risks.
PKF Francis Clark
The team at PKF Francis Clark is highly experienced at working with clients (management or buyers) to build financial forecasts to allow them to assess the future and sensitise for changes in key variables. The models have up to do now been used, in the valuation setting, arguably mainly for private equity investments.
Whilst I do not see the market approach fading away entirely (it is, as I have said thought to be well understood) but I do anticipate buyers and investors looking increasingly to the forecast cash flows and the risks associated with these as the arbiter of company value now and as we hopefully move to a post Covid-19 world.
We are well placed to assist in this area. Any questions please do not hesitate to contact me or your usual point of contact at PKF Francis Clark.