Corporate Value in a Corona World
Don’t throw the baby out
Value related issues are at the core of most major corporate decision making, whether in relation to strategy, investment, capital structure or M&A activity. Accordingly, it is not surprising that the boards and management of both corporates and investors are grappling with the value implications of the dramatic fall in, and ongoing extreme volatility of, global equity markets resulting from the coronavirus pandemic.
In particular, they are asking questions such as:
- how should we estimate corporate value in a corona world?
- how does corporate value in a corona world relate to movements in equity market values?
- how have shareholder return expectations changed and how should this be taken into consideration?
- are traditional valuation approaches still valid?
The good news is that traditional valuation approaches are still valid, and sensible outcomes can still be generated. It’s just that the results need to be taken with an even larger “grain of salt”. In these circumstances, other perspectives (such as strategic imperatives and resilience), sound commercial judgement and risk mitigation become even more critical in the broader decision making framework.
It’s the cash flows, stupid
Some commentators have argued that the most appropriate approach to dealing with the heightened uncertainty regarding value in the current circumstances is to simply increase discount rates (a coronavirus premium) and apply them to pre coronavirus cash flows. However, addressing the current valuation uncertainty in this fashion is unlikely to be helpful and may, in fact, result in misleading conclusions and poor decision making (or value destructive failures to make decisions!):
- the major coronavirus impacts on value will generally be cash flow related, often exacerbated by capital structure issues;
- there is no reliable and replicable way to translate estimated cash flow impacts into higher discount rates;
- increases in discount rates are arbitrary and ignore the differing duration impacts of the coronavirus for different industries and companies – some will recover much faster from the immediate impact than others, while long term impacts may also differ;
- some practitioners are applying both cashflow and discount rate adjustments, potentially double counting the coronavirus impact; and
- ultimately, the effect of a valuation approach that relies solely on an increase in discount rates will be to discourage a careful analysis and forecasting of the likely cash flow impacts of the coronavirus and the insights that can bring.
Accordingly, our recommendation is to:
- firstly, address the cash flow consequences, both short and long term; and
- then tackle the issue of discount rates.
Time to dust off the crystal ball
Cash flows are much more critical to making sound value judgements than theoretical debates about discount rates. Few acquisition disasters were caused by using a discount rate that was 0.5% too low. Rather, it is inevitably because the cash flows were fundamentally misconceived.
Common practice has been to develop a “best estimate” base case as the core element of value analysis. This short hand practice probably suffices in a stable world (as they say, the value of any model is conversely proportionate to the number of inputs). However, we would argue that, more than ever, there is a need to at least attempt to undertake a comprehensive scenario analysis (from pessimistic to optimistic) with probability weightings (even if based on an educated guess) attached to each scenario.
The cash flow analysis will need to consider:
- the extent of the short term earnings decline. Clearly, the impact is dramatically different depending on the industry and the company’s business model. For some, the picture may still be extremely clouded, but most should be able to make a considered estimate;
- the duration of the earnings decline before recovery commences. Again, the answer could be very different depending on the . As an obvious example, international travel bans (with their impact on airlines, airports, accommodation and other service providers) are likely to remain in place well beyond the opening up of shops and restaurants;
- the rate of recovery back to new normal conditions. How quickly do our customers bounce back and what constraints are there?
- the new normal level of earnings. Is it realistic to assume the business can revert, even over say 3-5 years, to previous plan expectations?
- medium to long term growth rates. Do we need to revise these downwards to reflect the lower economic growth and higher taxes expected as governments grapple with high levels of unemployment and massive deficits that will result from the stimulus/rescue packages that have been put in place?
- capital expenditure. Do current capital expenditure programs need to be revisited in light of any change in expected earnings or growth rates?
- terminal growth rates. Has the economy permanently changed?
Obviously, such forecasting is fraught with challenges given the unchartered waters in which we find ourselves. However, it seems to us that it is better to have tried and failed than not to have tried at all. At the very least, having to go through such a process usually provides useful insights into the critical factors that will drive value, the key risk factors and potential mitigants and, with luck, value enhancing opportunities.
Nothing is certain (but death and taxes)
The market dislocation of recent weeks prompts the obvious question for boards and management – should we change our discount rate as well as the cash flows?
Even at the best of times, discount rates are contentious. The cost of equity capital is not an observable phenomenon. It’s just inferred from a lot of other data, run through models to produce outputs and formulas of questionable statistical reliability and usually delivered as though it were factual and authoritative. It is only ever a theoretical assessment which needs to be applied with a strong dose of commercial judgment.
This is even truer in the current climate. We have seen a number of commentators and others declare that discount rates should be increased by amazingly specific amounts – 1.0% in one case, 0.25-1.75% in another. This assumed precision is meaningless, if not dangerous (never mind that such specific arbitrary adjustments are inconsistent with the theoretical basis of CAPM). The truth is, nobody knows and it is far too early to draw conclusions.
There are a number of arguments to support considering a change to discount rates:
- some evidence suggests that that the decline in market prices cannot be fully explained even by pessimistic changes to forecast cash flows;
- the premise of the CAPM is that capital investment decisions should reflect the return expectations of their (diversified) shareholders. The market now has a new perspective on risk (particularly “unknown unknowns”), with the potential impact of a major pandemic not fully priced in, and investors will now require higher returns.
Of course, the next time round it could be something different, but it is now apparent that there are events that can close borders worldwide and shut down entire industries, disrupt international trade and supply chains and cause massive impacts on government finances.
- even for companies that have enjoyed strong share price performance (supermarkets, some healthcare businesses) it is arguable that the risk premium has increased. Most of these businesses are expecting strong (even if short term) lifts in cash flows so a stable share price still implicitly reflects a higher discount rate;
- share price movements have been significantly different than would be predicted by historical beta factors and there is a case for both:
- believing that “true” betas are more widely dispersed away from 1.0; and
- rethinking the risk relative to the market for some businesses.
At the same time, if a true global pandemic is a one in one hundred year event the impact is negligible (and, by the way, measured historical betas over the next 2-4 years will be distorted); and
- credit margins have moved up materially over the past few weeks even for very strong credits. Obviously, this would automatically lead to an increase (albeit minor) in any WACC calculations but it is also supportive of a view that equity risk premiums (which are further up the same risk continuum) have also risen.
On the other hand, there are arguments that it is not really necessary to adjust discount rates at all:
- the last few weeks have seen a further step down in central bank interest rates and bond rates. Current expectations are that interest rates will remain even lower for longer (i.e. no reversion to previous long term averages). Accordingly, keeping the discount rate the same effectively already incorporates an increase in the risk premium;
- current equity market price levels may not reflect “fair value”:
- anecdotally, extreme market movements and volatility have been exacerbated by factors such as forced selling (e.g. margin loans) and high frequency automated trading which tend to settle relatively quickly. This could potentially be supported by a rebound in equity markets (albeit only time will tell); and
- there are arguments that the globalised and rapid access to information combined with human emotions (greed, anger, fear, panic, etc.) can deliver economic outcomes, including market movements, that are not otherwise explicable in conventional economic terms. Even if we seek to indirectly allow for this in our market risk premium, the implication is that significant movements in required rates of return are unlikely to endure, as these emotional factors can be expected to dissipate over time;
- corporates are making decisions with consequences that should ultimately be judged by the market over longer time frames. Accordingly, the relevant market risk premium is a longer term market risk premium. Once the pandemic passes, we will likely be in a low growth, low interest rate world. In these circumstances, investors will also have to accept lower returns; and
- over the last few years a practice evolved of not reflecting the apparently low risk premium implied by equity market exuberance (e.g. using discount rates well above CAPM calculated estimates). Leaving rates untouched is just the flipside of this practice.
So, what do we do?
Clearly, there is no obvious or simple solution. Nevertheless, investors will have to make real world decisions with consequences in the near future. We do not believe a prescriptive approach is warranted or sensible in the current climate. Decisions around discount rates should be tailored to individual circumstances. For example:
- if you are an asset owner that, prior to the coronavirus outbreak, had used relatively aggressive discount rates (with low implied equity risk premiums) then there is a case for adjusting the discount rate upwards; and
- if cash flows are highly predictable (e.g. infrastructure assets with minimal volume risk), there is a stronger case for leaving discount rates where they are, particularly having regard to the likely situation in 1-2 years time. On the other hand, if confidence in the cash flow projections is low then a higher discount rate than previously adopted may be a sensible compromise (even if not theoretically pure).
- the deferral of decision making (including in relation to value judgements) can be as destructive as hasty and inappropriate decisions; and
- history suggests that the current circumstances are likely to provide compelling strategic investment opportunities for companies that are well capitalised, well resourced, and decisive. Clearly, there will be key determinants of the ultimate success of investment/M&A transactions other than those that relate to value, including:
- base business resilience;
- capital structure and funding arrangements;
- strategic optionality;
- risk management; and
- management depth and bandwidth.
Given the uncertainties, it is tempting to throw your hands up and wait until it feels safe to go outside again. But the wheels of commerce grind on and boards and management will come to a point where they need to make decisions. Moreover:
The value analysis tools are there to support boards and management to make robust, informed decisions and take full advantage of the opportunities that will emerge from the uncertain times ahead. Just understand the limitations and apply plenty of that critical ingredient, common sense.
If you want to discuss any of these issues further, please feel free to contact any of the following senior members of our Value Advisory team: