This article discusses the effect of COVID-19 on valuation methodologies as discussed in a Webinar hosted by the American Society of Appraisers (ASA). The panelists included ASA’s, ABV’s, CBV’s and CFA’s from Canada, United Kingdom and United States.
Income Approach valuation methods include the Discounted Cash Flow and Capitalization of Cash Flow analysis.
Discounted Cash Flow Analysis
In the Discounted Cash Flow analysis, future cash flows are discounted to present value using an appropriate discount rate or rate of return. Cash flows are forecasted for a discrete period of years and then projected to grow at a constant rate in perpetuity. The discounted future cash flow method is more appropriate when earnings are expected to be materially different in the future.
Capitalization of Cash Flow analysis
The Capitalization of Cash Flow analysis uses forecasted cash flow for the next period, which is converted to present value using an appropriate capitalization rate, equal to the discount rate less the expected growth rate in perpetuity.
When valuing a small closely held business, the Capitalization of Cash Flow analysis is often used to determine fair market value as there is typically not expected to be a significant amount of volatility in revenues and cash-flows in the near future.
Which Income Approach Valuation Methodology is more appropriate during the COVID-19 pandemic?
With the recent uncertainty created by the COVID-19 pandemic, the use of the Discounted Cash Flow analysis may be more appropriate for the determination of fair market value for many small closely held businesses.
This methodology can factor in the expected short-term and long-term risks of the subject company by using dual or even multiple discount rates. A discount rate (risk rate) can be used for the period that COVID-19 is expected to impact the earnings of the company and a separate discount rate (risk rate) can be used for the period after business activity returns to normal.
The impact that COVID – 19 will have on fair market value is not going to be the same for all companies. Some company values will drop significantly, at least for the next year or two, while other will maintain their pre-COVID-19 value. The COVID – 19 crisis should not be used as an automatic reason to reduce the fair market value of a business. Instead, a careful analysis of the impact on the subject company should be done to determine its impact.
Our team of professionals at McCay Duff LLP are ready to work with you throughout this process. Contact your McCay Duff advisor today to get started!