Valuation matters, even more so in times of great uncertainty. We will discuss the impact of COVID-19 on valuation and equity markets by examining indicators such as analyst forecasts, beta factors, and share prices as well as discuss the shift in leading valuation methodologies in times of crisis.
The COVID-19 pandemic has fundamentally transformed our traditional way of life. Wearing masks, social-distancing, working from home, and travel bans are examples of the many actions that have been necessary to dampen the spread of the virus. Changes in consumer behaviour such as these have had a swift and deep impact on the capital markets.
Prior to the spread of the virus, we already experienced a period in modern history characterised by other highly impactful events that altered consumer behaviour such as globalisation, digitalisation, geopolitical conflicts and Brexit. The return of highly impactful events such as these is always possible and the corona virus pandemic underlines the fragility of our attempts to predict the future as it becomes increasingly challenging to find solid ground to develop and support robust valuation analyses.
In an attempt to assess the impact on global equity markets, we examined three indicators I believe help understand the situation even as it continues to evolve.
First, we examined analyst consensus forecasts by sector of the MSCI Europe index in an attempt to understand how their outlook has shifted. Using 31 December 2019 as a ‘Pre-COVID 19’ level to compare to our more recent date of 30 June 2020, we noted analysts adjusted their profit estimates downward across all sectors, with Energy, Real Estate and Consumer Discretionary averaging a considerable decline of 92.0 percent.
Second, we looked at recent share price changes across global equity indices, which showed a decline of 32.6 percent on average from 20 February to 23 March. All sectors, though, experienced partial recoveries by 30 June with an average loss of 11.0 percent over the entire period, hinting at a possible disconnect between analyst predictions and the not-so-bearish investor public, perhaps signalling wider anticipation of a V-shaped recovery despite a looming recession.
Third, we examined sector beta factors to understand their shift in risk profile. With meaningful increases across Energy, Real Estate and Utilities, the beta factors remained mostly unchanged in Consumer Staples and Communication Services with even a slight decrease in Healthcare, which perhaps confirms some of our intuition.
The turbulence created by the pandemic does not change the fundamentals of valuation. The generally accepted valuation methodologies, i.e. the Income and Market Approaches, remain relevant and will continue to lead going forward. What it does change, however, is the difficulty in finding solid ground to develop a supportable analysis which affects how commonly each approach is used.
For example, transactions closed before the pandemic no longer serve as strong indicative valuation inputs by themselves as their comparability has weakened. Furthermore, multiples implied from publically traded companies are likely heavily distorted for similar reasons, which significantly weakens the valuation professional’s ability to rely on the Market Approach. Due to this, we see the Income Approach as the leading valuation approach in the immediate future.
The discounted cash flow (‘DCF’) method, a widely used method under the Income Approach, has always served an important role in increasing the transparency of a valuation analysis. As more detail from the valuation professional is required as standard, the DCF often satisfies stakeholder requirements. During this current period of uncertainty, though, the use of the DCF as the leading valuation method has become even more relevant. For example, as we see limited partners (‘LPs’) of private equity funds requesting increasingly more detail on the valuations of portfolio companies, often derived under the Market Approach, general partners (‘GPs’) may only be able to meet this request by supporting the valuation using the DCF method.
Generally, the DCF method is applied first by deriving the ‘single most likely cash flow projection’ and subsequently discounting this projection back in time to the valuation date. It is commonly accepted, though, that in times of uncertainty such as now, the derivation of a single scenario is much less supportable than the use of multiple likely cash flow scenarios, weighted by their relative probability of materialising.
This so-called ‘probability weighted DCF method’ has been in use by many, including KPMG, for years in other uncertain environments, including past economic crises as well as frequently in the notoriously uncertain pharmaceutical sector. As this method often offers the highest level of transparency among those available, we find it now more than ever, the most appropriate valuation method going forward under current conditions.