To Understand The Adjustments Made For COVID-19 Era, First Understand The Income Approach That Is Typically Used For Business Valuations:-
In this approach, an equity interest become a function of two variables:
- Expected Economic Benefits
These can be in the form of the available cash flow for equity investors or equity and debt investors, or the earnings before tax.
- Discount Rate (based on the involved risks)
These can be in the form of the weighted average cost of capital (WACC) or the cost of equity.
The two variables would vary according to the two methods commonly used under the Income Approach:
1. Capitalization of Earnings Method
Here, the expected economic benefits for a representing singe period are tuned to the present value through dividing by the capitalization rate – the discount rate after subtracting the long-term sustainable growth rate.
Sometimes known as the CCF – or capitalized cash flow – method, this is generally appropriate for established businesses, such as real estate, that have a consistent capital structure and hence predictable earnings or operating income.
2. Discounted Cash Flow (DCF) Method
The value here is derived from discounts on a series of expected cash flow – typically refers to the terminal (or residual) value.
Theoretically, the terminal value refers to the expected cash flow in the final year of the forecasting period; hence it describes the worth of the business when its operations have stabilized. It can be derived via the capitalization of earnings method or the market approach.
With the DCF method, there is greater flexibility. Hence it is generally suitable for businesses that plan to change their capital structure in a short term or have high growth.
The COVID-19 Times Require A Valuation Method That Allows Great Flexibility:
It’s not surprising that the valuation experts in Singapore and Malaysia prefer the DCF method over the other since they can better adapt to the fluidity of the marketplace and any impending consequences.
They do consider an appropriate time frame for a DCF analysis, which is dependent on the expected period of disruption to the business operations. For now, most experts use a timeframe of at least three to five years; though there are many who consider longer ones.
Furthermore, the valuation experts are extra careful to not repeat count the COVID-19 incurred risk factors for the two variables mentioned above. Hence many of these experts are considering the impact of the pandemic in the forecasts, not the discount rates.
Making Adjustments for COVID-19 In Business Valuation Requires Special Attention To The Evaluating Inputs:
Since a business valuation is based on various sorts of inputs, its reliability is hence dependent on its inputs.
A typical input would be an estimate derived from the performance or results of the earlier years, adopting an average growth rate for the business’s working capital, variable expenses and revenue, and a constant fixed expenses. Inevitably, during the COVID-19 period, with the volatile circumstances, these previously viable simple inputs – or estimates – become less relevant, or even irrelevant in some industries.
The marketplace in Singapore and Malaysia has been constantly responding to the COVID-19 impacted circumstances:
- Public spaces – sports venues and schools – have closed down temporarily and many previously flourishing ventures across both countries – movie theatres, resorts and casinos – have started shutting down for good;
- New ways of reaching out to the masses, communicating for sales and income, are forced to develop and be adopted by those who strive to stay float in such social-distancing times – doctors and therapists are offering services through online platforms; restaurants and retailers are also using online platforms and delivery services to keep up with their sales; even food processing facilities have started offering their products and services directly to consumers;
- Businesses everywhere are also forced to change their cost structure: most people are now working from home, switching to online working and learning; there is a great reduction on non-essential travelling and a significant increase in reluctance to engage overseas suppliers;
- Government laws and regulations are also adapting to keep up with the changing circumstances.
With all the above happening, there is no telling which ones will be temporary or permanent. Although it is likely that the public spaces will resume normal operations – not sure when – to fulfill the daily needs, other cost-cutting arrangements like working from home and eliminating non-essential travelling will become the ‘new norm’ of living and working in Singapore and Malaysia, as well as commuting between the two countries.
Hence the previously accepted and widely used models would now seem oversimplified with unrealistic assumptions – using them would incur errors in the final business valuation. So business valuation experts who usually consider the management’s inputs for the forecasting of future cash flows must now evaluate that input, whether it is reasonable, before discounting expected earnings.
With the pandemic, today’s circumstances bear unprecedented conditions, and estimating future cash flows becomes even more challenging than before the pandemic.
This then calls for a qualified professional with an expertise in business valuation and updates of the latest trends and economic changes, who can assist to create the best forecast, substantiated with market evidence. He/she shouldn’t be using oversimplified assumptions or gut instincts, especially in such times.
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