In valuing operating businesses, the risk of a business is reflected in the multiple applied to cash flows. A higher multiple indicates a less risky business, which generates a higher value for the same level of cash flows than a riskier business.
Selecting the appropriate multiple for a business requires significant professional judgement and a valuator will consider the broader market, the risk of the industry and the specific company risk of the business, amongst other factors.
We expect that Covid-19 will have the following impacts on the multiple:
- Purchaser will be more cautious for a period of time which may lead to lower multiples. This is reflected in the equity risk premiums some firms are applying increasing (see Duff & Phelps update https://www.duffandphelps.com/insights/publications/cost-of-capital/us-equity-risk-premium-increased-march-25-2020).
- The multiple for industries seen to be benefitting in the long-term from Covid-19 will increase, while multiples will decrease for those industries negatively affected. What is important to highlight is that the multiples on an industry level will be most impacted by long-term trends caused or accelerated by Covid-19 rather than the short-term impacts of the virus. This could include trends such as working from home or habit changes around food consumption, for example.
- Changes at a business caused by Covid-19 can also impact the multiple. As examples, a business could lose a strong management team or its position as a market leader as a result of Covid-19. These changes could lower the multiple a purchaser would be willing to pay.
- The longer-term impacts of Covid-19 on multiples is not clear at this point. A multitude of factors will shape multiples in the long term, including the strength of the economic recovery, monetary policy and the longer-term trends impacting different industries.
While each business valuation is unique, overall multiples, with some exceptions, may be lower for a period of time with future changes being difficult to predict.
Questions to consider
These are some questions you should consider when advising your clients and working with business valuators:
- When updating a valuation issued before Covid-19 to a valuation date during Covid-19, are changes in the multiple consistent with changes in the market, industry and business?
- Are there industry trends emerging or evident that would change the risk associated with the industry in which the business operates? If so, have these been factored into the multiple?
- Has the business undergone significant changes that would impact the multiple? This could include the loss of key management or other factors specific to the company.