By Mohnish Zaveri, Sujay Dave and Avishi Agarwal

Law360 (January 25, 2021, 6:19 PM EST )

Mohnish Zaveri

Sujay Dave

Avishi Agarwal

The COVID-19 pandemic upended the global economy and equity markets continue to grapple with uncertainty over the full extent of business disruption, the timing and shape of recovery and the multiple waves of infections.

All of this uncertainty has driven market volatility to historic levels.

As shown in Figure 1, below, the average level for the Chicago Board Options Exchange volatility index, or CBOE VIX Index, has more than doubled during the pandemic relative to the preceding three years.[1]

In the face of sharp swings in equity prices and uncertain business prospects, disputes over business values, particularly in pending M&A transactions, have increased.

The volatility and uncertainty creates challenges for valuation practitioners and experts as they attempt to value enterprises in the midst of the pandemic. However, as this article notes, sticking to the valuation basics can help navigate the task of quantifying business value.

Figure 1: CBOE VIX Index


Starting in about March of 2020, the pandemic ushered in a wave of disputes over broken M&A deals like Xerox Holdings Corp. abandoning its takeover bid for HP Inc., Ally Financial Inc. calling off its acquisition of CardWorks Inc. and Texas Capital Bancshares Inc. and Independent Bank Group mutually agreeing to terminate their merger.[2]

In many instances, acquirers are citing coronavirus and material adverse effect clauses as a basis for walking away from the deals.

For example, Sycamore Partners, a private equity firm, recently cancelled its plan to acquire a 55% majority stake in Victoria's Secret, owned by L Brands Inc. Sycamore contended that L Brands' failure to pay rent and furlough of thousands of workers amid the coronavirus pandemic constituted a material adverse effect.[3]

COVID-19 factors are also emerging in valuation disputes like the J. Crew Group Inc. bankruptcy.

Deloitte Touche Tohmatsu Ltd., the biggest unsecured creditor for J. Crew, filed an objection to J. Crew's disclosure statement for failing to provide information on the impact of COVID–19 the company's valuation and its business performance.[4]

COVID-19 has also notably affected business sectors unevenly, with certain sectors like e-commerce, food delivery, and video streaming services benefitting, or at least recovering quickly from the pandemic, while others like hospitality, tourism, energy, and brick and mortar retail continue to suffer.

The technology sector has gained 22% while energy sector is down 26% from pre-COVID-19 levels as shown in Figure 2, below. It remains to be seen whether current trajectories will continue, revert to historical levels, or look completely different in the future.

Figure 2: Technology vs. Energy Sector Market Values


With all the noise and future uncertainty, business valuation has become a challenging exercise. Here, we discuss a few considerations for valuation experts when grappling with the economic impact of COVID-19, with the key takeaway being stick to the basics, but carefully think about the assumptions and inputs, which are used for a valuation.

Key Considerations for Business Valuation During the Pandemic

The two most common approaches to valuing a business are the income approach and the market approach. The income approach includes discounted cash flow analysis which involves projecting a set of future cash flows and discounting them to a present value using a risk-adjusted discount rate called the weighted average cost of capital.

Discounted cash flow[5] is considered theoretically sound but it can be sensitive to assumptions about the cash flow projections and discount rate:



In contrast, the market approach involves valuing a subject company by comparing it to other similar businesses, often through a value multiple — e.g., enterprise value/earnings before interest, taxes, depreciation and amortization, or EBITDA.

The idea behind multiples is that similar assets should sell for equivalent prices.[6]

In the case of companies, it is common to measure the market price as a multiple of some form of earnings variable. Companies with similar industry, growth, and risk characteristics — often called guideline companies or comps — should trade at similar multiples of earnings.

Multiples can be used to value both private companies and also to see how public companies are valued relative to peers.

Income Approach Considerations During the Pandemic

First, cash flow projections should reflect both the short and long-term impact of COVID-19 related disruptions.

In addition to reviewing management's historical performance in achieving projections, valuation experts should consider the recovery/growth scenario underpinning the projections and assess if they are in tune with consensus industry and macroeconomic expectations.

Management interviews can play an important role in uncovering these assumptions.

Second, a substantial portion of value under the income approach often comes from the subject company's terminal value — this is the value of the business at the end of the forecast period.

Terminal value is typically calculated using a multiple of terminal year earnings or a long-term expected growth rate for the cash flows.

In assigning a long-term expected growth rate, it is important to assess if COVID-19 has simply caused short-term disruption or a more permanent erosion in long-term growth prospects.

Third, the discount rate used to take the present value of cash flows is typically based, in part, on the prevailing risk-free rate and a market risk premium, which is the return investors demand from equities above the risk-free rate.

Recently, investors' flight to safety and federal monetary actions have caused the 10-year Treasury rate, a common benchmark for the risk-free rate to fall from 1.88% on Jan. 2, 2020, to 0.52% on Aug. 4, 2020.[7]

Since then the 10-year Treasury rate has gradually recovered to 1.1% on Jan 14 this year.

In tandem, the premium investors expect for investing in equity over risk-free assets has increased.

Duff & Phelps, which publishes market data often relied on by valuation practitioners, increased its recommended U.S equity risk premium from 5% to 6% on March 25, 2020.[8]

Duff & Phelps has since reduced the recommended U.S. equity risk premium from 6.0% to 5.5% on Dec. 9, 2020.[9]

Both of these factors appear to be shifting more abruptly than in the past and applying the most contemporaneous data will be important to capture the prevailing sentiment toward risk.

Fourth, while it may be tempting, valuation experts should try to avoid double-counting risk by applying both a haircut to projected cash flows and adding a premium reflecting company specific risk to the discount rate.[10]

American Institute of Certified Public Accountants guidance suggests basing cash flow projections only on information that is "known or knowable" as of the valuation date.[11]

Thus, to the extent possible, discounted cash flow valuation should use cash flows projections that fully incorporate the impact of COVID-19 known or knowable at that point in time and then discount them with a rate reflecting the forward-looking cost of equity and debt.

Market Approach Considerations During the Pandemic

The two most common methodologies under the market approach are called the guideline public company method and the guideline transaction method.

The guideline public company method values the subject company based on earnings multiples of similar publicly traded companies, while guideline transaction method values the subject company based on value multiples derived from the sale of similar companies.

Collectively these two methods are also called market multiples.

Market multiples are commonly used by bankers, analysts and practitioners because they offer a simple and fast way to value a business based on market data. Care must be taken in the selection of guideline companies however, lest the result be skewed too high or too low.

In light of the abrupt economic disruption caused by the pandemic, the manner in which market multiples are applied is more important than ever. Take for example a guideline public company that has been negatively impacted by the pandemic — i.e., future earnings will be negatively impacted — call it Company A.

Company A's current enterprise value is $1 billion. Last year it earned $200 million, but next year it is expected to earn only $100 million. A market multiple for Company A is therefore 5X earnings based on the last 12 months, but 10X the next 12 months.

If used as a guideline line company for valuation purposes, Company A could result in substantial over or under valuation of the subject company depending on your perspective.

Both forward multiples and trailing multiples can be used by experts, and as this example illustrates, the choice of forward vs. trailing can impact the subject company's value greatly.

Valuation experts need to develop a consistent framework for their guideline companies to appropriately reflect the current disruption and potential future recovery, or lack thereof.

For certain industries, which expect a longer path to recovery, a forward multiple based on expected normalized earnings may be more instructive for relative valuation.

Given the unique uncertainty created by the pandemic, however, more than 218 companies in the S&P 500, about 40% of them, withdrew quarterly or annual forward guidance in the spring and summer of 2020 which may constrain the data available to perform certain forward multiples analysis. [12]

Just as with the guideline public company method, the pandemic has exacerbated the challenging task of identifying comparable transactions under the guideline transaction method.

Academic research shows that investors are less willing to invest during periods of heightened uncertainty, which could manifest itself in lower levels of deal activity or transactions or lower multiples than periods of normal economic activity.[13] Through the third quarter of 2020, COVID-19 has resulted in a 32% year-over-year decline in transaction value and 13% year-over-year decline in number of transactions as shown in Figure 3 and 4 below.

Figure 3: Deal Activity —  No. of Transactions                                                             



Figure 4: Deal Activity — In Billions


Guideline transactions that were executed during the pandemic require scrutiny to determine if they represent an orderly transaction, especially if the subject company valuation assumes it will continue operating as a going concern.

As a matter of practice, it is not uncommon for valuation experts to consider transactions executed two or more years prior to the valuation date of interest, but transactions consummated pre-pandemic may have been based on prices and earnings projections that are now out of sync with current market conditions.

This all means that the valuation expert must carefully evaluate and justify each guideline transaction as suitably comparable despite rapidly changing economic conditions.

Similarly, looking forward, transaction multiples from the COVID-19 period may need scrutiny to see if they can be applied for valuing companies post the COVID-19 pandemic.

In sum, the pandemic has caused a massive disruption to the economy and created a host of challenges for business valuation. Volatility has increased.

Industries are being impacted disparately. Discount rates are shifting with rapidly changing market conditions. The selection of comparable companies and transactions, and the appropriate multiples to apply requires heightened level of consideration.

Sticking to the basics, however and critically evaluating inputs and assumptions used in a business valuation will provide the most credible result.

Correction: A previous version of this article misstated author Avishi Agarwal's title. The error has been corrected.

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Mohnish Zaveri is an associate, Sujay Dave is principal and Avishi Agarwal is a research analyst at The Brattle Group.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] CBOE VIX is based on options of the S&P 500 and is widely considered as a gauge of U.S. equity market volatility.

[2] S&P Global, "More than $100B of M&A deals terminated amid 'new world order' of COVID-19", June 25, 2020.

[3] Reuters, "Sycamore Partners invokes MAE clause in bid to escape Victoria's Secret deal", April 22, 2020.

[4] Deloitte Objection to Proposed Disclosure Statement at 3, Chinos Holdings et al, No. 20-32181-KLP, June 18, 2020.

[5] https://corporatefinanceinstitute.com/resources/knowledge/valuation/dcf-formula-guide/

[6] Tim Koller, M. Goedhart, and D. Wessels, Valuation: Measuring and Managing the Value of Companies, 7th Edition, Wiley, p. 389. ('The basic idea behind using multiples for valuation is that similar assets should sell for similar prices, whether they are houses or shares of stock.").

[7] Department of Treasury website, https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/TextView.aspx?data=yieldYear&year=2020.

[8] Duff & Phelps, "Duff & Phelps recommended U.S Equity Risk Premium increased from 5.0% to 6.0% effective March 25,2020", March 27, 2020.

[9] Duff & Phelps, "Duff & Phelps recommended U.S Equity Risk Premium increased from 6.0% to 5.5% effective December 9,2020", December 9, 2020.

[10] Aswath Damodaran, "Strategic Risk Taking", Chapter 5, p. 35.

[11] Journal of Accountancy, "Professional Guidance in Business Valuation: Applying SSVS1", September 2007. Statement on Standards for Valuation Services (SSVS) are issued by AICPA Consulting Services Executive Committee.

[12] WSJ, "Coronavirus erases guidance from 40% of S&P 500", June 28, 2020.

[13] Bhagwat, Dam & Harford, "The Real Effects of Uncertainty on Merger Activity", July 20, 2016.

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