COVID-19 is impacting how practitioners value target companies for M&A purposes. How are valuation practices changing and what stays the same? Let’s take a look.
Guideline Publicly Traded and M&A Transaction Comparables methods’ influence over a final valuation range should be reconsidered during this crisis.
First, looking at the M&A Transactions method, Revenue and EBITDA multiples are based on how prior, similar M&A transactions were priced at close. M&A transaction multiples are based on a unique combination of factors of the target company’s profitability, growth and risk. A disruptive shock like COVID-19 throws uncertainty in all 3 attributes for most companies. Typically, we apply transaction multiples from up to 6 years in the past. However, 2013 to 2019 was a stable, growing economy. At this time, industries are being impacted and reshaped by this worldwide pandemic. To rely on M&A multiples from M&A transactions from 1-6 years ago now seems less relevant.
Along the same lines, the Guideline Publicly Traded Company method reflects how a group of public companies that are similar to the target company’s business is trading. Trading multiples of a comp set’s Enterprise Value to Revenues and EBITDA are then applied against the target company’s trailing 12 months’ financial performance.
How do we gauge industry comps in a crisis however? You could pick a few dates in time for the comp set selected, and observe the impact of how multiples changed from several key dates: December 31, 2019 to February 19, 2020, the peak of the S&P 500, to March 12, 2020 when there was a 20% drop from the peak, and the current date. How did the industry comp set group fair on these dates in terms of stock price, market capitalization, revenues, EBITDA, and P/E multiples? This will give you an understanding as to how an industry is responding to the crisis.
When applying those multiples against a trailing 12 months for the subject company being valued, the practitioner, as always, determines how much influence the trading and transaction range should have on the overall valuation range. There is a credible argument that these comparable methods should be deemphasized, and the Discounted Cash Flow method (DCF) should have greater influence. Most companies have unique risks ahead that their management team will have to address. As stated earlier, due to the uniqueness of the path forward for every company, applying comparable multiples based on a group of public companies seems less relevant now. I am not suggesting you disregard these methods, just deemphasize them in their overall influence on a final valuation range.
One additional point to make on these methods. Regarding the target company’s baseline “TTM” Revenues or EBITDA used to apply the multiple against, one could argue for one-time adjustments during the COVID period. Those adjustments would be validated by a return to normalcy after the COVID emergency period. Practitioners will have to look at these adjustments carefully in order to determine what is acceptable and what is not.
Discounted Cash Flow method. A significant step in conducting the DCF method is the forward-looking projections exercise, typically 5 years into the future. With the pandemic, one could argue that you should split the projections into 2 “buckets.” The first bucket is a COVID period for companies. You would have a COVID cash flow period split out and discounted back to present. Then you would forecast the rest of a projection period separately, up to 5 years into the future. Near to intermediate term projection assumptions should be revisited by all companies. How does management anticipate the company will perform in the first 12 months post outbreak? Forecast that period next. Then forecast the next 12-24 months post outbreak. Then forecast a final period consisting of projected years 4 and 5. Those projections would then be called a “base case scenario.” A “downside case” and an “upside case” should then be forecasted separately. Come up with 3 different versions of the DCF valuation range. As stated earlier, the DCF method should have greater influence on the final fair market valuation range.
The art of valuation is always about both assessing quantitative and qualitative factors. Often the quantitative is the easy part. Management competency must be more closely scrutinized in a post-COVID recovery period. Most managers are navigating through a crisis. Valuations that were prepared before COVID-19 will face heightened scrutiny because almost no company is operating in “business as usual” conditions. Your ability to defend valuation assumptions will be a significant step in reaching a Letters of Intent and Purchase Agreement.
I want to thank the Alliance of Mergers & Acquisitions Advisors and its’ members, including Ken Heuer with Kidd & Company & Chris Mellon with Valuation Research Corp. for several of the insights that I am sharing in this article. For further information and questions please contact me at 864-527-5960.