There's no doubt that COVID 19 has had and will continue to have a significant impact on the global economy. While it is anyone’s guess as to the depth and duration of that impact, it's important to remember that every situation is unique; the impact on companies and their assets' values will vary depending on industry, geographic location, and strategic response. Join Tanner Shaw as he discusses the impact that COVID-19 has had on financial reporting valuations.
[00:00:09] JL: Welcome to today's edition of DHG’s GrowthCast. I'm your host, John Locke. At DHG, our strength lies in our technical knowledge, our industry intelligence, and our future focus. We understand business needs and are laser-focused on company goals. In this ever-changing world, DHG's GrowthCast provides insights and thought-provoking conversations on topics and trends that address growth opportunities and challenges in the current and future marketplace. Thanks for joining us as we discuss tomorrow's needs today.
[00:00:42] ANNOUNCER: The views and concepts expressed by today's panelists are their own and not those of Dixon Hughes Goodman LLP. Always consult the advice of your legal and financial professional before taking any action.
[0:00:58] JL: Today's guest is Tanner Shaw, a senior consultant in DHG’s Forensics and Valuation Services line. Tanner is a CPA and is accredited in business valuation and works out of DHG’s Birmingham office.
[0:01:14] TS: Good to be here, John.
[0:01:16] JL: Tanner, starting with the most pertinent and pressing question, how does the COVID-19 crisis impact 12/31/19 impairment testing valuations?
[0:01:28] TS: From a valuation perspective, subsequent events are generally not considered, so it kind of comes down to one way to determine an event to be known or knowable. As far as a 1231 valuation date for domestic US companies, typically it’s the COVID crisis kind of hit the United States after that point, so it typically wouldn’t be explicitly considered. However, there are circumstances where it might be necessary to update a valuation to a more recent date or, in more cases, to kind of stress there some of the key inputs and assumptions that were used in that analysis as of 1231.
The other thing that we see with impairment tests as of year-end or for year-end audits is that the calculations a lot of times will be prepared before that maybe into the third quarter or the first day of the fourth quarter. That just gives internal and external auditors plenty of time to review and get comfortable in the analysis and the conclusions. In normal times, that works well for everybody since not a whole lot will have changed between the first day of the fourth quarter start and December 31.
But in situations like this where there has been a lot of change, sometimes we’ll see if not an update to a more recent date, just some more procedures around confirming the reasonableness of those assumptions that the outcome and the conclusion is correct.
[0:02:59] JL: So definitely a lot of different dates to be mindful of, Tanner. Is there a general consensus on a date that marks the beginning of the economic impact or a certain cutoff date for excluding consideration?
[0:03:12] TS: There has been some consensus around the end of February in the beginning of the economic impact at least domestically in the United States. That’s kind of the point where we will start thinking about considering that impact as noble and potentially providing some estimates and looking at the key assumptions and inputs from that perspective. But it really depends on the facts and circumstances individual to the subject company and its industry. In some cases, companies might have seen significant impacts in January or much earlier in the year. For example, some companies that are heavily dependent on Chinese manufacturing might have seen serious supply chain disruption as early as the beginning of the year, so that’s stuff to be considered on a case-by-case basis.
[0:04:03] JL: Well, what are some specific considerations that need to be made for valuations being performed during this period of time?
[0:04:11] TS: Well, I think specifically in valuing closely held companies. We're generally relying less on public company market multiples than maybe we did in the past. When the market approach is relied upon, you always have to consider it. That’s kind of a principal of what we do. But when you're really going to rely on it, we just have to spend a lot more time to confirm the consistency of the public comps and the company and kind of the data on both sides of that to confirm that we’re comparing apples to apples, so to speak.
Since the public company financial data, their estimates are constantly evolving and being updated. We have to make sure that if the COVID impact is fully accounted for in the subject company investments, and the company and management's projections consider that impact, then all of the comparable company data also has to be updated and considered similarly. That’s just an additional consideration that we have to make when using the market approach.
Then from the income approach side, really the impact is two-pronged. First in estimating the appropriate discount rate and then confirming the expected or the normalized cash flows. As far as the discount rate is concerned, some of the inputs might be directly affected by changes in the market and some might be company-specific, so we need to look closely at the changes in perceived risk, cost of debt, changes in capital structure in really for both the subject company and the guideline public companies were applicable. That’s part of it.
But the bigger and generally more challenging piece is really the actual cash flows. People generally think of risk and the uncertainty being primarily factored into the discount rate because there are specific places to do that. It’s part of the buildup of that calculation to consider additional risk but it should also be equally factored into the cash flow projections themselves. From that end, I think we’ll see a lot more scrutiny of management-prepared projections during this time.
[0:06:21] JL: When you say scrutiny of the projections, what exactly do you mean by that?
[0:06:26] TS: The company's financial projections have to come from the company, and nothing is changed in there. But just as analysts preparing a valuation during difficult times, we have an increased duty to just kind of go back to stress testing assumptions. Making sure that forecasts are reasonable and confirming that all those factors and inputs and aspects of that financial forecast is updated and has been reconsidered from “normal times” and things that might traditionally be considered stable and reasonable and acceptable without a whole lot of time, energy, and effort, discussion around those factors. Those things sort of matter more in times where potentially there would be some shifts and some major changes.
That just means asking more questions and spending more time in the weeds, so to speak, to make sure that we have a good understanding of the situation specific to the company, asking things like has the working capital needs changed in the short term? Or the capital expenditure estimates that might've been compiled as part of the 2019 board presentations, are those still reasonable? Are there short-term and long-term growth rate impacts that need to be considered?
Then as detailed as operating expenses, have operating margins been affected in the short term? If a sharp rebound is forecasted, what’s kind of rational to support that expectation? In other words, is the rebound in 2021, at least in large part, a factor of strategic decisions that have been made by the company or other company-specific factors or are they more or less in anticipation of improving market conditions? Just being able to understand the expectations of the company and management and the rationale behind those expectations so that we can factor in any additional market risk into the discount rate, so the two things are very interlinked in that way.
I mean, these are challenging areas to nail down even in the best of times with the income approach. So when things are particularly uncertain like this, it just becomes all the more important to corroborate results using multiple methods, doing a lot of sensitivity testing, running different scenarios in order to get comfortable with all the key assumptions and ultimately the outcome.
[0:09:00] JL: Well, let’s set aside the traditional transaction related to fair value calculations for a moment. What are some other types of calculations that you’re expected to come up with during this? How are those going to be affected?
[0:09:13] TS: Realistically, any valuation that would be prepared ordinarily as of a given date if it’s something that’s done annually, those will come up, and many of the considerations will be the same. Other things that come up at a point in time that isn’t always predetermined would be stock options, equity gifts. ESOPs have to be valued at the date of grant and then generally on the annual basis thereafter. Depending on internal happenings within any company, there will be kind of valuation needs that present themselves during this time. For the most part, those things are going to be impacted by kind of the same issues and additional contemplations that need to be made that we discussed before.
As far as fair market value calculations, most of those will be related to gift and estate tax purposes and in some cases litigation matters or shareholder disputes. Those are all things that, again, we don't get to pick the timing of it, so those pattern will continue to come up during this period of time and will involve kind of the same considerations on the market approach and the income approach but then also have a few additional considerations around potentially higher discounts for lack of marketability to take into account the follow-up of M&A activity and potentially some illiquidity issues.
[0:10:43] JL: You mentioned a follow-up of M&A activity. Has there been an observable impact on the number or type of transactions occurring?
[0:10:51] TS: Yeah. M&A activity has slowed significantly as expected towards the end of the first quarter of 2020 and here so far in the second. I think that’s probably a result of just traditional banks supporting that capital has been bogged down in some cases, and a lot of private equity has been taking somewhat of a wait-and-see approach here in the short term. Of course, there's speculation of pent-up demand and the school of transactions on the horizon, but there’s plenty of uncertainty in that regard I think on that logistic. We’ll have to wait and see.
[0:11:28] JL: Well, is it safe to say or assume that the value of companies and companies’ assets are lower?
[0:11:35] TS: Well, they’re saying lower now than they were, say, this time in 2019. I think that’s – You can’t say it just in such a straightforward way, but there is no doubt that COVID, this whole pandemic has had and likely for many companies will continue to have a significant impact. But at the same time, it's important to remember that every company is unique and their situation is different. Some companies have actually been performing exceptionally well throughout all of this and in some cases as a result of the pandemic. I mean, healthcare-related textile and manufacturing companies obviously had been doing really well due to the need for facemasks and other hospital and healthcare-related needs.
But also technology and telecommunication companies are seeing significant revenue growth in the short term due to all the people working from home and all the remote needs in terms of technology there. All that is just to say every situation is unique and, again, has to be considered on a case-by-case basis and will vary depending on the industry and the company, the geographic location, and also just management, the strategic response to this.
[0:12:55] JL: We’ve been hearing a lot about the Payroll Protection Plan known as the PPP loans. Are there valuation concerns being discussed around the PPP?
[0:13:05] TS: For sure there are, but that’s definitely an area that’s still being discussed and, again, will be specific to the individual circumstances but particularly what portion if any of that loan is expected to be forgiven. The loans will definitely have to be a consideration, and in some cases they might be considered extraordinary income and excluded. In others, the portion of the loan forgiven might be considered nontaxable revenue, which would offset the lower cash flows from operations. But like you said, that’s an area where new information is forthcoming continuously and kind of updates are being made there, so that might be a good secondary topic [inaudible 0:13:47].
[0:13:47] JL: Yeah. I was going to say stay tuned on that one, right? Well, Tanner, thanks so much for your time today. It’s wonderful to be able to gain some insights on how companies are being valued now and some of the dates that are critical for folks to pay attention to. I really appreciate your insights and having you with us today.
[0:14:07] TS: Absolutely. Anytime.
End of Interview
[0:14:10] JL: Well, you’ve been listening to the DHG GrowthCast with Tanner Shaw, Senior Consultant with DHG’s Forensics and Valuation Services Group. We hope you have some additional insights into how businesses are going to be evaluated as we move through the COVID-19 economy.
I’m John Locke, your host, and I look forward to having you back on a future episode of DHG GrowthCast.