At such times of uncertainty, and the fragility of one’s point of view about the virus impact on economies and industries, valuations are exceptionally challenging. Sticking to the basics of fundamentals is an extremely important, disciplined approach to the company valuation. Thats why the Valuation at the time of the epidemic is different.
Valuation is an art
Valuation is an art, professor Damodaran once said. Indeed, finding the intrinsic value of the business is an art. It is equally important for business owners and investors to know the true value in the proposed project and understand its drivers. Valuations have been relying on past performance – Pre-crisis historical financial data – and future assumptions.
At the time of crisis, the gap between past performance and future performance has been widening, hence, putting the valuation method in question under review. It is healthier and wiser not always to assume past performance will repeat itself in the future. However, ones can not ignore them (historical data). Moreover, the model assumptions are embedded with such uncertain predictions, specifically for a longer time frame valuation. The impact of the epidemic on economies requires a deeper digging to understand which industries are most negatively affected and the ones that are positively affected and the contribution of each to the total GDP.
“It is precisely times like these that matter most, You need to go back to the first principles of valuation. Everything I have learned about valuation has been in the context of a crisis,” said Prof. Aswath Damodaran at the CFA institute annual virtual conference.
Adjustments
Sticking to principles and put it in the context of a crisis as Prof. Damodaran put it. Thankfully, he did putt for us some adjustments framework to the discounted cash flow method,
- How will earnings growth be affected in 2020 and how much of this impact will linger for the long term? The current year will be a bad one, but it’s just as important to figure out how much earnings will recover by 2025 or 2029.
- How will fears about the future affect what percentage of earnings is returned to shareholders through dividends and buybacks? As companies get nervous about what lies ahead, they return less cash.
- How will the risk-free rate, 10-year US Treasury bonds, be affected by a flight to safety, fears about the economy, and central bank actions? US T-Bonds yields made a major move downward from 1.59% on 14 February to 0.64% on 1 May 2020.
- How will investor risk aversion be affected by fear of a market sell-off as reflected in the implied equity risk premium (ERP)?
When valuing companies, Damodaran emphasized the importance of creating a story to go with the valuation, about how the sector will play out after the crisis and whether your company will emerge stronger or weaker.
In closing, Damodaran offered some reassurance. “It’s all going to be okay,” he said. “Go back to basics and the fundamentals and be willing to live with uncertainty. If you’re wrong, revisit your valuation.”
Other Methods of Valuation at the time of the epidemic
Other methods of valuation are more challenging to apply than the discounted cash flow (DCF). Precedent transaction method for example, as it appears from the name it is “Precedent” which means the impact of the epidemic has not been discounted in the value. Other comparable methods are easier to apply like multiples, for example, P/E, P/B, P/S, EV/EBITDA. Comparing Peer companies, in the same industry, which are all affected more or less the same way from the epidemic and investors have discounted the effect on the prices already. There are more challenges in applying any of the above-mentioned methods, but for this article, we have been more interested in the impact Valuation at the time of the epidemic.