Has COVID-19 devalued your business?

If you are selling your business, merging, acquiring, or inviting in new investors, you need to understand the value of your business. But, to what degree does the pandemic impact on value? Should you discount or hold firm to pre COVID-19 performance on the basis that ‘we’re going to come out of it eventually’?

Fair market value reflects the price a knowledgeable, willing (but not overly eager) buyer and seller would agree on in an open market, dealing at arm’s length within a reasonable timeframe. Value and price often differ. The price you offer or receive usually depends on how motivated each party is. For example, if a seller doesn’t need to sell and the business offers synergy value to the buyer, they may demand a premium. Even in a quick sale, the price may hold if the business’s liquidated asset value is high, meaning the parts are worth more than the whole.

However, to understand the value of a business, the pandemic necessitates a depth of investigation beyond the norm:

You cannot simply ignore the pandemic and rely on pre-pandemic performance and financials, even if you are enthusiastic about the future. Previously, anyone looking to buy or sell a business would likely analyse the past three years trading figures to help determine a value but this historical analysis may no longer present an accurate picture. For some businesses, history is no longer a reliable predictor of fair value.

The Government controls put in place to contain COVID-19 transmission – closures, social distancing, border and travel restrictions – have a material economic impact. Closures and distancing impact in different ways and need to be considered at both an industry sector and individual business level. Government stimulus packages may also be providing abnormal short-term outcomes.

For some businesses, the operating and financial impact is material. And, this may flow into the underlying value of the business.

All valuations consider present and emerging risks and the current and anticipated business environment. This analysis is then brought into the modelling and valuation conclusion.

COVID-19 creates its own set of considerations for analysis, including:

• COVID-19 impact at an economic, industry sector and business level.
• The supply chain across the customer and supplier base with a view to identifying possible COVID-19 impacts in the supply chain.
• Earnings normalisation including the removal of stimulus support measures. For the 2020 year, a deeper analysis is likely to be required with possible segmentation by quarter.
• Current and forward year position (see Forecasting during a pandemic).
• COVID-19 risk in applying earnings multiples.
• COVID-19 related assumptions.

A hypothetical investor might have been prepared to pay $1 million for a business. That business might be on offer for $800,000 and appear as if the investor has struck a bargain. But, the business might actually only be worth $600,000, and not such a good deal after all.

Take the hypothetical example of a printing business:

The business has operated for over 10 years with a strong track record, generating $5-6 million in revenue and $800-900k Earnings Before Interest and Tax (EBIT) annually for the past three years. It services more than 400 active clients and maintained consistent trading patterns up to March 2020. Between March and June 2020, revenue dropped 40% as the business closed or operated on a limited roster for eight weeks during the initial COVID-19 lockdowns. It is now returning to normal operations, though this recovery isn’t yet reflected in revenue. Given its solid trading history, the COVID-19 impact may be considered temporary.

The largest customer of the business represents less than 2% of total revenue. The next two largest customers represent just over 1% of revenue. Two of the three customers have resumed their pre COVID-19 printing order levels. A large number of customers seem to spend between $5-20k per annum with the business.  

However, during a customer sensitivity analysis, it’s found that 70% of customers are from the live entertainment sector. As a result, the business is likely to have a material downturn until the entertainment industry resumes or the business is able to replace the business it has lost. A consequence of this is that value may be impacted.

Almost all businesses are valued by one of two methods:

The first is the industry approach, where sales of similar businesses are used for comparison. The basis of this method is that the market provides a reliable indicator of value. This method works best in a stable and active market and where recent history is a reliable indicator of the present.  But, COVID-19 casts doubt on the reliability of past sales that occurred outside of pandemic conditions.

The other typical method of valuing a business is based on its maintainable earnings. Valuers use this method for businesses with a trading history where it’s likely that the value of the business will exceed the underlying value of its assets.

This method determines:

• The future maintainable earnings of the business,
• An appropriate earnings multiple, and
• The value of any assets surplus to the core business.

The multiple applied to the business may be impacted by COVID-19 as the multiple falls as risk increases. For example, a business that was valued at four times earnings pre-pandemic might achieve a lower multiple as the pandemic presents a risk to the likelihood of the business achieving earnings consistent with pre-pandemic conditions.

Unlike the ASX, there is no index to indicate the value of private businesses. The pandemic has added significantly greater complexity to the valuation process. This means buyers and sellers should work even more closely with their advisers before making a decision.

Looking to purchase a business and would like a due diligence completed? Contact us for more details on the steps to take.

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This is general advice only and has not been prepared with your situation and needs in mind. For individual and personalised advice, we highly recommend that you seek out proper professional advice from your business adviser.