Business processes will change due to the pandemic and so should the way valuations of companies are done
Coronavirus cases are rising exponentially in India even as the country is in the midst of unlocking the economy. With the Government allowing almost all sectors to restart, companies are faced with the new challenge of valuing their businesses as a consequence of the pandemic. Nothing is the same now. The financial markets, the economy, real estate and almost all sectors have seen major turbulence and the uncertainty will not end anytime soon. According to the 2020, Brand Finance India 100 report, during the pandemic, the combined valuation of India’s top 100 brands dropped by $25 billion as compared to the start of this year. The uncertainty in future cash flows is now a hard reality. Organisations have to renew ways of measuring risks associated with the cash flow of their businesses as the categories of risk may have increased in the light of Covid-19.
The elements which are a part of the discount rates used in valuations, including the risk-free rate and unsystematic risks, may have changed, altering the way businesses approached valuations before the crisis. All business valuations are done on projections. However, in these unprecedented times, there is every chance that these projections might change. It has become difficult to quantify the short-term and long-term financial projections and the shape of economic recovery is also uncertain. It may be ‘V’ shaped, ‘U’ shaped or even ‘W’ shaped. Moreover, some industries may bounce back faster than the others. Even though governments across the world are providing economic stimulus, the fact remains that consumer demand may still be slow and may possibly see a paradigm shift in the long-term.
So, during these times, selecting a valuation model relevant to one’s own business is imperative. All three valuation methods — income, market and asset — are available to business managers and analysts. However, in the present situation, some methods may be more appropriate as compared to others. For example, of the two income-based approaches that are used to value a company, one may be more appropriate than the other now. The first method, the Capitalisation of Cash Flow (CCF) method is used by mature firms, which are relatively stable in their growth expectation and cash flows. Under this method, the valuator assumes a steady growth rate, picks a single income stream and predicts future income based on historical numbers.
On the other hand, the Discounted Cash Flow (DCF) method is more flexible and allows for more variations in the future cash flows based on varying growth rates, changes in the interest rates of debt repayments and any other factors that may change in future and could affect cash flows. Given this rising economic uncertainty and market disruption, DCF, with its flexibility to allow modelling of performance of future years of a business individually, with varying growth rates and cash flows till businesses stabilise, may be a more useful method. This method will not be devoid of challenges as valuators may still have to consider multiple scenario analysis to capture the growing uncertainty in the next 18 to 24 months.
Organisations can value their business using other methods as well. However, additional considerations need to be applied in doing so. For example, if a company was using the market approach of valuation earlier, it needs to make relevant adjustments in the financial parameters now. It may not just use an average of the previous three or five-year period, as it may not be applicable in these uncertain times. So usage of previous years’ financial metrics during these times needs more analysis and adjustments.
Cash flows and the ability of a business to continue its operations and generate cash flows are important for business valuation. In addition, cash balance and the rate at which money is being used by an organisation also determine its survival and ability to continue doing business. So any changes that help a firm to preserve capital and cash flows, now and in the near future, will help in the valuations as it can give a good idea of how long a company can survive in these turbulent times.
The longer-term prospects of any organisation are also important in assessing its value. However, every dark cloud has a silver lining and tough times help some companies to thrive or re-engineer themselves, like grocery and food delivery, manufacturers of PPE and digital businesses. These and similar other businesses by virtue for their relevance in these times, or because of timely reinvention, are actually booming during the outbreak. With world economies going through disruptions and maybe permanent changes in consumer behaviour, some companies would take advantage of the situation and do better than pre-pandemic times. Going forward, due to the unpredictability of the business environment and future cash flows, valuations cannot be done by just numbers. Stories of survival, tales of flexibility and the ability to either scale up or scale down at a short notice should be definitely part of valuations. Many things may not remain the same in the aftermath of the outbreak. Business processes will change and so should the way valuations of companies are done.
(The writer is Associate Professor, Amity University, Noida)
