Coronavirus and the Expert Witness: Valuation Instructions

The Coronavirus, and the disease it causes ‘Covid19’ have had a catastrophic impact on the economy and in turn stock markets. Stock markets, whilst not always perfect or rational, nevertheless represent an immediate reference point for company valuations.

The impacts on stock markets started to be seen around 19 February. Between the 19th and March 20 the FTSE dropped 30%, with the S&P 500 down 25%.  And whilst we have seen what is referred to as a bear market rally (or a ‘dead cat bounce’) in the last week of March, history teaches us that the markets are likely to have further to fall before recovering their losses (hence the rather unfortunate feline analogy).

The markets will recover their losses – but three reference points for forensic valuations have been thrown into chaos – earnings, multiples and asset valuations.  For most companies it is hoped that the impacts of Covid19 will only be short-term (say 1 – 2 years), but for the foreseeable future – longer than 2 years - the job of the Courts to interpret the impacts on matrimonial assets has just been made exponentially harder.  

Expert valuers need to be alive to the Covid19 impacts, and instructing solicitors need to be wary of how they instruct valuations, and indeed, who they are instructing.  A vanilla approach to valuation might have been proportionate ordinarily; it is not likely to be sufficient in future.

Earnings

It goes without saying that in a period of economic upheaval, company profits will be impacted.  But the valuer needs to beware of the exceptions.

There are some companies operating in sectors that will see an uptake in demand.  Food, logistics – even the aviation sector, is seeing cargo operations compensate for the loss of passenger flights.

An assessment will need to be made as to whether Covid19 is an exceptional event which needs to be ignored in the valuation, as part of the earnings normalisation process; or whether there has been such a fundamental change of the company’s value drivers that the value of the business has been materially changed – which might also mean an increase in value.

An earnings-based valuation is predicated on the basis that the company can forecast profits.  These are typically estimated by reference to historic profits.  Clearly recent trading performance is no longer a reliable indicator; worse, if the most recent year features a ‘Covid19’ loss, then the estimate process becomes trickier.  This may inform the need to value by reference by to an extended number of historic periods and change the way those years are weighted.

Multiples

Typically, a multiple is applied to the forecast earnings of a trading company, to derive a value for that business. Multiples can be accessed from a variety of sources.  Without exception, these will be based on historic transactions – which completed pre Covid 19 – or by reference to quoted multiples, e.g. the FTSE.  Consideration will need to be given to adjusting those multiples – a highly subjective exercise. When you consider FTSE multiples are down by 30%, the arbitrary unquoted adjustment to them makes valuation reliability even more questionable.

Debt Adjustments

A company’s value is divided amongst its stakeholders – this is typically the shareholders, but some of that value will be allocated to long term debt. The shares of a company valued at £1million that has a bank loan of £100,000, are not worth £1million, but £900,000.

Many companies will be looking to extend bank overdrafts, and also look to take advantage of HM Government schemes to facilitate lending to business, to keep the UK economy afloat.

Valuations will thus see the double whammy of reduced values, and increased debt, depressing the value of the shares yet further. That won’t be an exceptional blip – but a long-term impact on the share price. As will the loss of surplus cash, which serves to mitigate the debt adjustment impact on the valuation.

Property and Assets

Companies that are valued by reference to their assets are not immune from Covid19. The market for residential and commercial property has evaporated, and banks are reducing their security valuations on such assets by as much as 80%.

Surplus assets such as cash and investments will be used up as companies access emergency cashflow to keep their operations afloat.

Corona Corruption

Even businesses that are not immediately impacted may suffer the consequences (or even be the perpetrators) of behaviours where Covid19 is used as an excuse not to pay, even from debtors that have liquid assets. An increase in litigation is likely. Great for commercial lawyers, less ideal for valuers trying to assess the impacts of potential legal claims on a company valuation.

Liquidity

One thing we can be reasonably certain of is that the economy will come back, and with it revenues and profits.  But the first casualty of an economic crunch is cashflow – and the last to recover.  Companies delay paying debtors to hang onto cashflow on the way in, and on the way out, growth puts demand on working capital.  Questions as to liquidity are perennial features of expert witness instructions.  Don’t expect much liquidity any time soon.

Instructions

It amazes me how rarely I have been asked to consider the impact of Brexit on a company valuation instruction. However, Brexit pales by comparison to Covid19.  Instructing solicitors will need to be incorporating this into their thinking, and their valuation instructions – but also be alive to share owning applicants and respondents who will look to ‘over egg’ the impact.

We’ve Been Here Before…

I have been valuing businesses long enough to remember the last stock market crash – 2008. All the issues outlined above, presented back then. The valuation solutions then are no different to those that will apply now. The difference is that since 2008 many valuers have entered the forensic valuation scene who haven’t grappled with the thorny problems we are now faced with – and will have to learn to, fast.

The market always comes back, but before it does there will be a period of volatility – not just in stock market prices, but in forensic valuations.  The bar will be raised in terms of the standard of expert witness work – a standard valuation approach will not cut the mustard in these challenging times, and the ramifications of getting this wrong are stark for all concerned.

Chris Walklett FCA

Chris is a tax partner for Bishop Fleming LLP.  In addition to being a tax and valuation expert he is a Cardiff Law school accredited expert witness and a member of HMRC’s expert witness panel.