The Cost of Capital Dilemma: Valuation During Abnormal Market Conditions
The Michel-Shaked Group’s Israel Shaked (Managing Director) and Brad Orelowitz (Senior Vice President) and Paul Dionne (Manager) published an article in the April 2021 issue of the American Bankruptcy Institute Journal discussing key considerations for valuation professionals to assess during abnormal market conditions. Specifically, they discussed valuation during the COVID-19 pandemic and the importance of normalizing valuation inputs.
A common methodology employed by valuation professionals is the discounted cash flow (DCF) method. One of the key inputs into the DCF is the discount rate, typically represented by the weighted-average cost of capital (WACC). The importance of the discount rate, and the sensitivity of valuation conclusions to even small changes in the discount rate, requires increased scrutiny of discount rate assumptions by all parties to the dispute. In normal times, it is important for a valuation professional to bring substantial support for the assumptions and inputs into his/her discount rate calculation. However, during periods of abnormal market conditions, such as the COVID-19 pandemic, it becomes even more imperative for valuation professionals to substantiate their assumptions and ensure that inputs are normalized.
During periods of abnormal market activity, such as the COVID-19 pandemic, inputs used in a WACC calculation, such as beta or the risk-free rate, can become skewed due to the unusual nature of the event. It is important for a valuation professional to understand the impact that an abnormal market event has on a company’s WACC. Further, it is essential for a valuation professional to determine to what extent the cash flow projections of the subject company incorporate the impact of COVID-19.
COVID-19 has severely affected many businesses around the world. Many restaurants, retailers and movie theaters have been forced to close their doors. Although the impact of COVID-19 on certain companies and industries has been substantial, it is reasonable to assume that the negative effects of the pandemic are not going to last forever. A valuation professional needs to consider this carefully when performing going-concern valuations of companies during COVID-19.
For example, the DCF methodology projects cash flows for the subject company for more than 20 years (discrete period plus terminal value). Specifically, the terminal value, which calculates the value of the subject company in perpetuity, accounts for all of its cash flows following the discrete period. Therefore, the DCF methodology accounts for cash flows long after the COVID-19 pandemic ends. If the subject company’s cash-flow projections already reflect the impact of COVID-19, increasing or decreasing the subject company’s discount rate (due to the pandemic) could result in a double-counting of the pandemic’s effect. As a result, a valuation professional might unreasonably double-penalize the subject company’s value.
Using their recent experience as expert witnesses in the Tailored Brands and Chesapeake Energy bankruptcies, Israel, Brad and Paul demonstrate how abnormal market activity caused by unforeseen events (such as the COVID-19 pandemic) can impact companies differently. For example, in the case of Tailored Brands, the beta of its peer companies increased as a result of the COVID-19 pandemic. However, in the case of Chesapeake energy, the beta of its peer companies decreased. The question then becomes – is this increase or decrease in a company’s beta caused by the abnormal market activity from COVID-19 representative of the company’s systematic risk in perpetuity? Furthermore, is it appropriate to use the (observed) discount rate which is temporarily skewed (whether upward or downward) due to COVID-19 to value a company in perpetuity? In both of these case studies, projections prepared by management already reflected the impact of COVID-19. Therefore, using an abnormal WACC to discount cash flows that already reflect the abnormal event (COVID-19) would be clear double-counting.
Abnormal market activity caused by unforeseen events (such as the COVID-19 pandemic) can impact companies differently. Whether it is valuing a company during COVID-19 or during other abnormal events with a finite period, it is essential for the valuation professional to determine to what extent the cash flow projections of the subject company already reflect the impact of the abnormal event. If the projections already do reflect the impact of the abnormal event, the valuation professional should consider using normalized inputs during the valuation process. If the valuation professional does not, he or she runs the risk of double-counting the impact of the abnormal event and concluding on a value that is incorrectly higher or lower than the best estimate of the subject’s fair value.