“Cash is king” has never been truer than during the pandemic that has rocked the business world in the past 3+ months. Some businesses have looked for assistance in how to get cash to keep their operations afloat, while others have been hoarding cash as the fear of a second wave looms in the back half of 2020. Cash flow is the lifeblood of a business and when analyzed can tell us a lot about what is business is worth. We can examine at the cash flow or earnings the business generates through the lens of the riskiness of those earnings to glean an idea of the business’ value to a potential buyer. To say the least business valuation during COVID-19 is proving to be tricky.
Cash flow can be a fairly straightforward measure when viewed historically, but valuation methodology relies entirely on future cash flows. It is hard to remember a time when future cash flows have been so difficult to predict, but here we are.
A few primary questions arise:
- How do we contend with the current economic climate to put past and current earnings in perspective?
- What might the recovery look like and how does that impact our expectations of the future cash flow of a particular business?
In addressing the first question, valuation methodology can allow a valuator to use historical cash flows to project future cash flows and determine value using a capitalization of earnings. In the capitalization of earnings method, a multiple is applied to historical earnings to calculate a value for the business. In using this method, the valuator is essentially saying that future earnings will be the same as historical earnings indefinitely into the future. That statement may be an extremely difficult one to defend given the current economic environment. So, the valuator may conclude the using historical earnings is not the best way to determine value.
If we cannot use historical earnings, we must look towards projected earnings to use in our discounted cash flow method. But, using projections does not come without its fair share of issues. More questions than answers may arise when trying to put together financial projections for both the short-term and the long-term. How long may a recession last? Will the recovery be v-shaped or u-shaped, or some other shape we aren’t really even sure is a shape? Will the business see 6 months of earnings deterioration, or will a second wave cause another round of closures and expenses outpacing revenue? As we can imagine, the task of putting together reliable projections is not a straightforward one.
Ultimately, valuation is based on future cash flow, and the pandemic has thrown a wrench into everyone’s idea of what future cash flows might be for businesses across most industries. It is easy to say that since many businesses saw a drop in revenues and an increase in expenses due to the virus, valuation is depressed, and in some cases to a significant extent. But, valuation is by its nature, a long-term practice. Valuation assumes that businesses continue indefinitely. So, is the pandemic just a blip that is barely visible for an indefinite-lived business? Or, will it continue to have negative impacts on cash flow long into the future? The answer to these questions will continue to play out in the coming months and years and business owners and valuators alike will be keeping an eye on the cash every step of the way.