The Pandemic Effect: Caveat Emptor
Caveat Emptor and Covid19
Caveat emptor (Latin for “Let the buyer beware”) has become even more relevant in today’s markets for both public and private companies. The phrase caveat emptor and its use as a disclaimer of warranties arise from the fact that buyers typically have less information than the seller about an asset or business interest they are purchasing (sometimes referred to as ‘information asymmetry’).
In the second quarter of 2020, buyers, sellers, and valuation professionals are dealing with the impacts of the Coronavirus disease on every part of the global economy. Given this, typical valuation approaches may fall short. In fact, almost every accepted approach to valuation should be scrutinized for its applicability (and required adjustments) in this environment.
Market methods relying on multiples are some of the most frequently used methods of valuing assets and businesses. These methods typically take known prices or values and compare them to other metrics to create market multiples. Common multiples include price-to-earnings (“P/E”) ratios for equity interests, Earnings Before Interest Taxes Depreciation and Amortization “(EBITDA) multiples for entire companies, and dollars per square foot or acre for commercial real estate.
Under normal or steady-state market conditions, valuation professionals often apply metrics to a trailing profit measure that is known and measurable, as opposed to an analysts’ or owners’ estimate of future earnings. Today, however, given the economy is shut down for an unknown length of time and consumers will ultimately control the rate and degree of eventual recovery, the amount of money made last year has less value as an indicator of future expectations.
Forecasts / Discounted Cash Flows
The income approach, most often observed in the form of a discounted cash flow analysis, addresses the expected future earnings and cash flows of a business. These future earnings are discounted to a present value today at a risk-adjusted discount rate. Again, under normal or steady-state market conditions, a single forecast is often used for these calculations. Given the high level of uncertainty regarding the future alignment of recovering demand with excess supply, a single forecast or outlook may not adequately reflect a large range of potential outcomes.
One method of dealing with future uncertainty is to consider a range of potential forecasts (e.g., base case, high and low cases). Another option is to consider a seemingly infinite range of potential outcomes in a Monte Carlo analysis. Key-value drivers such as demand, pricing, and costs are modeled to reflect the market and other sources of volatility. The end product allows the user to understand the range of potential outcomes and to develop confidence intervals around a potential offer.
Risk-Adjusted Discount Rates
Whatever forecasts are considered above, future expected cash flows will be discounted back to a present value in order to determine a value. In academia, the capital asset pricing model, notwithstanding its shortcomings, is the most referenced means to calculate a discount rate. However, given the current low level of US Treasury interest rates, combined with historical equity premia, this model currently predicts an expected equity cost for the S&P 500 of around 7% per year. However, equity markets have been trading up and down several percentage points per day, indicating that at the present time this model does not adequately capture current levels of market risk.
Another term for “risk” is “volatility” and the CBOE’s Volatility Index (“VIX”) reflects investor views of market volatility. As shown below, the current level of the VIX is approximately double its level over the last few years.
Under these specific market conditions, applying academically accepted models with standard inputs could result in a buyer significantly over-valuing a potential transaction.
Caveat emptor, quia ignorare non debuit quod jus alienum emit (“Let a purchaser beware, for he ought not to be ignorant of the nature of the property which he is buying from another party.”) is of critical concern to market participants in these uncertain times. Given that business valuation is a learned craft, market participants should retain credible firms with experienced professionals to ensure the factors above are considered and applied appropriately.
If you’re looking for more information on business valuations or just need some advice, contact us today.
Greg Scheig, CFA, CPA/ABV, CEIV is the Managing Director at Vantage Point Advisors Dallas office with over 30 years of consulting and valuation experience. Mr. Scheig holds an M.B.A in Finance and Accounting and a B.S. in Petroleum Engineering both from The University of Texas at Austin. Mr. Scheig is a Chartered Financial Analyst, a Certified Public Accountant in Texas and is Accredited in Business Valuation and Certified in Entity and Intangible Valuation.