Valuation Considerations Amid the COVID-19 Crisis
The World’s economic activities have become severely affected since February due to the outbreak of COVID-19. Governments have imposed travel bans, quarantine measures and various business operating restrictions to limit the spread of the virus. This has resulted in unprecedented elevated market volatilities. Stock market indices fluctuations of +/-10% daily are not uncommon. In valuation practice, volatility is translated as risk and a key parameter in pricing an asset. However, quantifying such risk is challenging as the situation is still developing, and there are no clear indications as to when the pandemic will subside.
Use of hindsight
As highlighted in the World Health Organization (“WHO”) COVID-19 timeline, whilst a cluster of cases were first reported on 31 December 2019, it was not until 30 January 2020 that a global pandemic was announced, and more widespread measures started to be put in place across different countries. We should note that valuation is date-specific, and it should only rely on information or expectation that is already known or available on that date. In other words, the use of hindsight (aka ex-post information) from a market participant’s perspective is not typically allowed in a valuation.
Therefore, for valuations dated 31 December 2019 prepared for accounting reference purposes, such as fair value measurement, impairment testing or expected credit loss (ECL) assessment, or for other purposes, risks resulting from COVID-19 should play a minimal role in an actual valuation. As there is often a time-lapse between the year-end date and reporting date, relevant disclosures under IAS 10 Events after the Reporting Period might instead be required. For valuations dated 31 March 2020, which is another popular financial year-end date, the effect of COVID-19 should play a critical role in actual valuations.
Back to the definition of different valuation bases
In IFRS 13 Fair Value Measurement, fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. The principal market (or if not, the most advantageous market) and the highest and best-use of assets are also assumed. In response to the development of COVID-19, we should revisit these assumptions for their validity and make corresponding adjustments whenever appropriate.
Amid elevated market volatility, we should also be aware that illiquidity increases as market activity decreases, that market participants are reluctant to transact, and they may even not be able to perform any due diligence work due to travel restrictions. Discount for lack of marketability (DLOM) will therefore substantially increase, and this will negatively impact the fair values of the assets and liabilities. The degree of DLOM to be applied will need to be based on available research and the valuer’s professional judgement. For valuations performed under the basis of fair value less costs of disposal, the results might also be affected as transaction costs are expected to increase.
Value-in-use valuations, on the other hand, should be handled differently. Value-in-use is defined as “the present value of the future cash flows expected to be derived from an asset or cash-generating unit” in IAS 36 Impairment of Assets and it does not assume a “transfer” or “exchange” of assets. It primarily focuses on the cash flows projections and the discount rate. When performing such discounted cash flow calculations, it is essential to ensure that the projected cash flows represent management’s best estimation on a set of reasonable and supportable assumptions and that the discount rates are developed correspondingly on the same basis. Similar principles also apply to fair value valuations under the Income Approach.
Required Rates of Return and Credit assessments
The capital assets pricing model (CAPM) is a widely adopted fundamental model to derive the rate of return on equity investment, aka the cost of equity. In an enterprise valuation, the cost of equity is combined with the borrowing rates, aka the cost of debt, in accordance with the enterprise’s capital structure, to form the weighted average cost of capital (WACC). The WACC will then be used to discount the projected cash flows to present values.
However, at least in the short term, the CAPM appears to be insufficient to fully reflect the additional risks brought by the COVID-19 outbreak given its non-diversifiable nature. Like the size-premium and company-specific premium typically added to the cost of equity implied by the CAPM, a risk premium for COVID-19 is worth considering in an Income Approach valuation. Since not all companies and industries are affected to the same degree, an appropriate risk premium should ideally be determined on a case-by-case basis using available market data.
On the other hand, for most companies, their businesses and operations are negatively affected, and this may result in breaches of covenants, and other terms and conditions of their borrowings with banks or other creditors. In other words, their creditworthiness may become worse during the current situation. We should, therefore, revisit their current borrowing rates to see if any adjustments would be necessary to derive a proper cost of debt and hence WACC in valuations.
Further to this, since IFRS 9 became effective in 2018, reporting entities are required to assess and report the amount of ECL of their financial instruments. An assessment will need to incorporate the best available information on past events, current conditions and forecasts economic conditions. Among the assessment procedures, it will be crucial is to determine whether there is a significant increase in credit risk and then whether a lifetime ECL should be calculated. The IFRS Foundation and the International Accounting Standards Board recognise the difficulties in assessing the ECL and will provide further guidance when appropriate. In the meantime, again, we recommend going back to basics, use definitions of the standards and follow guidelines provided by regulators and authorities, if any.
As a result of the COVID-19 outbreak, there are increased uncertainties during the process of valuations due to unavailability of market data, increased bid-ask spreads, limited choices of valuation methods or models, etc. Yet, the International Valuation Standards (IVS) do not forbid valuations with uncertainties to be performed. IVS 103 Reporting requires disclosures when valuation uncertainties are considered significant, and sensitivity analysis could be performed to quantify them. Any restrictions of information, the inability of inspection or special valuation assumptions should be clearly stated in the valuation report.
For valuations prepared for accounting reference purposes, despite the valuation uncertainties and limitations, they should adhere to the requirements set out in the respective accounting standards, including the hierarchy of inputs stipulated in the IFRS 13 Fair Value Measurement that highest priority should be given to Level 1 inputs, i.e. quoted price, and lowest priority to Level 3 inputs, i.e. unobservable inputs.
For more details about how we could assist you in the relevant assessments, please contact your local Moore Firm.
This article was written by Kenneth Ma, a Corporate Finance specialist from Moore Hong Kong.