This article was originally published by The Lawyer’s Daily, published by LexisNexis Canada Inc.

COVID-19 has had a significant impact, whether temporarily or permanently, on the earnings and value of many businesses. With the news of the vaccine rollout, temporary impacts, which started with the pandemic lockdowns, should soon start to fade. However, the value of a business could vary significantly depending on the valuation date and the current stage of the pandemic.

Business valuations during COVID-19 can prove challenging given the various possible outcomes available at the date of publication. One key principle of business valuation is that value is principally a function of future discretionary cash flows; historical results are only as reliable as the expectation that these results are indicative of the future prospects of a business.

Industry guide during COVID-19

The diagram below displays the general impact of COVID-19 on particular industries. The inner ring represents industries least affected, while the outer ring represents industries severely affected. There are exceptions within each ring, and the impact to businesses in these industries may be temporary or permanent.

In the inner ring, businesses with exposure to government, technology, utilities or consumer staples have stayed relatively immune or even benefited from the acceleration of certain trends.

Middle-ring industries, such as real estate, industrials, health care and financials, have not been as severely impacted on the whole.

However, businesses in the outer ring have been severely impacted by COVID-19. There are some exceptions, such as grocery and dollar store businesses, within the retail category.

It is the role of the business valuator to determine if the impact is permanent or temporary for the business and industry. Moreover, whether the valuation date is before or after the vaccine rollout will have an impact on how valuators determine the prospects for future cash flows.

Key COVID-19 valuation considerations:

• COVID-19 creates a situation where numerous unknowns exist
• Scenario analysis of various future results can be helpful 
• Do not overestimate or underestimate cash flows

Numerous unknowns lead to uncertain future outcomes. In addition to normal business risks, these unknowns include another shutdown, vaccine date rollout(s) and government support timelines.

Scenario analysis is a highly useful tool in a valuator’s toolkit during COVID-19. Scenario analysis utilizing probabilities can help market participants assess various uncertain outcomes. For example, businesses severely affected by COVID-19, such as restaurants, can map out various prospective cash flows in different scenarios.

When considering the cash flows of a business, there is a tendency to either over- or underestimate; this must be avoided when valuing the business. It is important that the expected cash flows are realistic in light of company, industry and market changes. For example, a tour operator may have been severely impacted during the COVID-19 lockdown and the cash flow forecasts of the business have to consider the appropriate time period and when the cash flows are projected to normalize as the industry recovers.

Active businesses

At the date of this publication, the total number of businesses in Canada have declined by approximately 8% since December 2019.

As illustrated in the chart below, April 2020 had the highest decline, with approximately 90,000 businesses closing, representing twice the monthly average business closings in 2019. The majority of business shutdown has been concentrated in the construction, retail, hospitality and food industries.

General valuation observations

• There is a flight to acquire quality businesses
• Interest rates are at record lows, making equity interest attractive while equity risk premiums have increased
• Dry powder (i.e., financial acquirers’ war chests) has further increased
• The Government of Canada has implemented relief measures for businesses; these must be normalized by valuators

Valuation date and COVID-19 impact

One key principle of valuation is that it occurs at a fixed point in time; it is not supposed to consider hindsight. Even though a particular business, such as a fitness and recreational sports center, may have been affected significantly by COVID-19 at the particular valuation date, the potential future impact on cash flows by COVID-19 may not be applicable due to the hindsight concept.

For the valuations with dates between January and March 2020, no one right answer exists as to how COVID-19 was supposed to play out. We note that the World Health Organization (WHO) issued a global health emergency on Jan. 31, 2020. Italy locked down entirely on March 9, 2020, and the WHO declared COVID-19 a pandemic on March 11, 2020. Between March 12 (Quebec) and March 22, 2020 (Nova Scotia), every Canadian province declared a state of emergency.

Business valuators performing valuations between those dates need to consider the business operations, industry impacts and management team insights around those dates. For example, an entity with manufacturing operations in China would have had management mapping out a potential international COVID-19 spread as early as February 2020.

It appears that before January 2020, the concept of COVID-19 was not foreseeable and thus of negligible concern to business valuations. However, business valuations with dates between January and March 2020 may involve a single scenario or multiple scenarios addressing the impact of COVID-19 on future discretionary cash flows of a business. Furthermore, business valuations with dates before or after the vaccine announcement date may have multiple recovery scenarios mapping out future discretionary cash flows. Hindsight is usually 20/20, just not as it relates to business valuations.