Valuations in times of market uncertainty

Despite the increasing evidence of the effectiveness of vaccinations on COVID-19, the impact of future government imposed restrictions is still unknown. In addition to this, new variants may also have a knock-on effect on inflation and supply chain shortages, with industries such as travel and hospitality being negatively impacted.

From changing consumer attitudes to the transition to net zero, there are a number of significant factors driving an increased focus on ESG. The impact of ESG needs to be acknowledged for companies to fully understand the value of their business.

The impact of the end of the UK Coronavirus Job Retention Scheme (furlough) in September 2021 is yet to be fully seen, as employees who were made redundant will still be included in the payroll data while they serve out their notice periods. However, evidence suggests that a significant majority of the 1.1million workers on furlough at the end of September 2021 remain in employment. Other labour market challenges seen in the UK include the automation of lower skilled jobs and increased vacancies, driven by the furlough scheme discouraging moves across firms and reductions in staff from the EU. Labour market shortages will also exacerbate supply chain disruptions, with industries struggling to regain momentum due to a lack of key workers.

Despite formally leaving the European Union in January 2020, with the transition period ending in December 2020, markets and businesses continue to be impacted by the ongoing issues created by Brexit. There are significant impacts on supply chains, as companies struggle to fill their workforce, with many foreign workers, who filled vacancies, returning to their homes during the pandemic. This is set to continue to cause business and consumer disruption in the near future, with post-Brexit visa rules making it harder for EU nationals to work in the UK. As a consequence, the UK is still underperforming in capital markets, with UK stocks largely at a discount to reflect the risk.

With the risk of investing in China increasing, from increased political risk and the inherent supply risk of having goods manufactured across the globe, businesses may restructure their supply chains as they look to move away from riskier suppliers. In addition to this, they may look to move away from just-in-time systems, making the supply chain less efficient and causing unit costs to increase. The key here is how easily these costs can be passed onto consumers, or whether this looks set to have a long term impact on margins.

VC and technology continue to operate at unprecedented levels, which is reflected in high valuations and multiples. The sustainability of these valuations should be a key consideration and may warrant a much larger range of possible outcomes being considered (typically through sensitivity or scenario analysis).

• Deferred revenue: It is not just earnings and cash flows that require discussion / challenge. For businesses in the travel sector, or where there are large amounts of deferred revenue, it may be the case that with bookings / income dropping off, there will be working capital shortfalls that need to be filled. This will clearly impact the valuation.
• Liabilities: It is also important to check that businesses are operating at their normal working capital level, as any surplus / deficits will need to be factored into the valuation. Any other excessive liabilities such as rent and tax deferrals should also be captured in the valuation.
• Real estate assets: 2021 has seen, in general, a gradual increase in the confidence of investors. In line with this, RICS has recommended that material valuation uncertainty declarations are no longer required for all assets (although leaving discretion for valuers to still include where they consider appropriate). Individual sector performance has not been uniformly impacted:
  • Retail - The sector continues to face challenges, however to varying degrees depending upon the type and location of the assets. Shopping centres: High vacancy rates continue to see downward pressure on pricing, particularly where they are anchored by fashion sector tenants where CVAs remain a risk (note, conversely those that are anchored by grocery / supermarkets have seen less impact). Edge of town retail parks: In a number of cases, there is targeted investor focus on these, either because footfall and spend has held up relatively well or where there are good prospects for repurposing to logistics usage. High street assets: very location specific and on strength of covenant / potential to repurpose.
  • Office - There is a clear bifurcation within the market. Prime, well located office properties with modern specifications and good ESG/Net Zero credentials continue to be in demand (particularly in central London) from both tenants and investors. However, assets located in secondary locations and without the same ESG/Net Zero credentials face a far less certain future. Pricing for such assets has been hit as valuers soften yields and build in significant capex, void and re-letting assumptions into their valuations.
  • Alternatives - Logistics industrial assets are heavily in demand, as are newer asset classes such as single family rental residential and data centres along with selected hotels.
  • Net Zero - While much of the focus at COP26 was on moving away from fossil fuels, emissions from the buildings sector was also an area of focus in terms of aligning targets. For commercial real estate sectors, the 2050 vision is for all buildings (new and existing) to be net zero carbon across the whole lifecycle. As an interim ambition, all new buildings should be able to achieve zero carbon in operations and aim to reduce carbon emissions by 40% in 2030. Building compliance with these targets, along with existing Minimum Energy Efficiency Standards requirements to let a property moving from an E (since 2018) to a B in 2030, are increasingly being factored into property valuations.

When scoping the valuation of a business with high levels of debt and/or limited debt servicing headroom, valuers will need to consider whether we can base our valuation on a going concern basis. Other metrics to consider are profitability, cash burn rate and covenant compliance. It may be more appropriate to assume that the business (or some segments within it) need to be valued on the basis of being put into run-off i.e. on a gone concern basis.

Fair value requires us to assume an orderly transaction ( i.e. an appropriate period and amount of marketing in advance of the transaction). If the valuation is not for financial reporting then valuers will need to be mindful of the real risk of a business having short term liquidity crunches, which would mean needing to consider a distressed rather than an orderly transaction.

As these distressed transactions occur, the financial metrics arising from them will need to be treated with caution for the purposes of cross-checking to financial reporting valuations going forward. And even if the valuation is indeed for financial reporting, if the business being valued is in distress, valuers will still need to assume an orderly sales process but might need to factor in larger illiquidity adjustments to ensure that the valuation is grounded in commercial reality.

In the immediate aftermath of COVID-19, we suggested that illiquidity adjustments might be required to discount rates for assets in sectors where we were observing that the marketplace had frozen up or its efficiency had diminished to some degree. We were careful to clarify that this adjustment was not the same as the ‘alpha’ adjustment as while alpha and illiquidity adjustments are related, they are not the same thing. By contrast, the UK is now experiencing a Deals Led Recovery, which would suggest that for many sectors, due to the availability of capital and demand for good assets. We are seeing an open and strong transaction market across most sectors. This means that illiquidity adjustments, to reflect a drop in M&A transactions, are unlikely to be relevant now in most cases. However, in certain sectors such as aviation, oil & gas, and the hospitality industry, we are still seeing distressed deals, where illiquidity may remain a relevant factor. Of course, standard illiquidity adjustments may remain appropriate depending on the nature of the asset being sold.

At the current time, we believe that the Capital Asset Pricing Model (CAPM) and other established methods for calculating the cost of capital should continue to be used. As these approaches rest upon a theoretical basis which should hold in general – including in times of an economic downturn – there is no reason to adjust the general approach for calculating the cost of capital. However, a review of each input factor seems appropriate and assessment of the overall result is certainly required. For instance, the use of a normalised or smoothed risk-free rate may be advisable if a particular daily spot risk-free rate appears out of line with other days as a result of market volatility. Given the overall decline in risk-free rates and stock markets at the start of the pandemic, even if a spot risk-free rate was being used, it may have been necessary to consider an increase in the equity market risk premium from previous levels. However, equity markets have since staged significant recoveries with a number of global indices exceeding pre-pandemic levels. This suggests that broader market discount rate inputs may actually be indicating lower discount rates than those seen prior to the start of the pandemic.

There has been significant differentiation in how sectors have performed (and even large variation within sectors) and this should be considered when carrying out valuations. This is likely to be primarily through ensuring appropriate adjustments to forecast cash flows, but it is also necessary to consider any potential impacts on the specific discount rate inputs for individual sectors (i.e. the beta). Whilst lower discounts rates supporting higher valuations in some sectors that have been resilient to COVID-19 may be appropriate, in other more impacted sectors, discount rates may need to be higher to reflect the increased uncertainty and volatility that is present.

Applying increased scrutiny to previously assessed betas is appropriate to ensure that expected sector volatility is appropriately incorporated within the discount rate. Due to the extreme volatility experienced in March 2020 (and to a lesser extent February and April), there can be a disproportionately large impact from the data in these months on the beta calculations, in some cases causing betas to double or halve from previous levels. It may be appropriate to exclude the data from these particularly volatile months in certain circumstances to ensure the beta isn’t disproportionately weighted towards data from this highly volatile period. Whilst changes in beta may well be justified given the shifting patterns in sector performance, these changes should also be grounded in general expectations for the expected performance and relative volatility in the sector going forward, rather than just mechanically applied from historical data.

Other components of the cost of capital may need to be adjusted to take into account industry, geographic or company specific risks arising out of current market conditions. Therefore, valuers must consider (on a case-by-case basis) whether the actual, current debt margins should be applied (or not) in order to estimate an appropriate cost of debt (e.g. depending on whether a company is funded short-term or long-term, the necessity of future (re)financing, promised vs. expected yield, assumption whether observed spreads persist indefinitely, etc.). The same principle holds for the appropriate target debt/equity ratio which, in general, we might expect to be lower relative to equivalent historical ratios in certain sectors due to the constraints on current debt financing packages.

Additional care must be applied when relying on observable recent market transactions to benchmark DCF valuation analyses. If we observe heightened short-term volatility in share prices, it may be appropriate to use average trading multiples over several weeks instead of daily multiples and to review analyst forecasts (as an additional source of benchmark data). However, market prices should still be used as a plausibility check for our valuation results as there is a clear need to take into account all market evidence.

Given the increased uncertainty, valuers might expect valuations to:

• Have more volatility associated with them. It is important to flag this to the users of valuations up front, particularly if those users are planning to rely upon them from a commercial perspective or where the valuation exercise is a recurring one;
• Have wider ranges, more scenarios and/or sensitivity analyses; we have provided further valuation guidance on the key uses of scenario analysis;
• Have point estimates within those wider ranges that are based more on judgement than underlying financial metrics in these times of heightened uncertainty; and
• Be accompanied by higher levels of disclosure in the case of financial reporting valuations. Those disclosures may wish to explain to the user that valuations could potentially change quickly over short periods of time (particularly where the subject business is highly leveraged).