David Anderson is principal of David Anderson & Associates, a Philadelphia forensic accounting firm that provides a full range of fraud investigation, forensic accounting, and marital dissolution services in Philadelphia and the Delaware Valley.
In my previous blog article, I discussed how the date of valuation for a business valuation has been affected by the COVID-19 pandemic; in this blog article, I discuss how business income which is used as the basis for valuing a business has been affected.
Most small-sized and many medium-sized businesses do not keep budgets and forward-looking financial projections. As a result, the valuations of these businesses use historical operating results as the basis for their valuations. This is used in the Capitalization of Earnings method.
However, this historical information will not take into effect the COVID-19 pandemic. If no budgets and forward-looking financial projections are available, then the primary way to adjust for the COVID-19 pandemic is to adjust the Company Specific Risk factor and expected long-term growth rates used to capitalize the earnings (alternatively, the Equity Risk Premium could be adjusted).
When calculating the Company Specific Risk factor, the business valuator must consider, among others, the following questions:
- What industry is the company in?
- What has been the impact of the COVID-19 pandemic upon the industry?
- How and to what degree has the company been affected?
- How long will it take the company to recover to pre-pandemic impact operating levels?
- If the company has furloughed or laid off staff, how will it re-staff, and how long will it take to achieve the re-staffing?
- Has the company lost any critical employees? If so, what has the impact been, and how long will it take to replace those employees?
- Has the company lost customers, will it be able to recover those customers, and how long will it take to do so?
- Has the company lost key suppliers/vendors, will it be able to recover those suppliers/vendors, and how long will it take to do so?
- Will the company still be able to retain its outside financing, and if not, will it be able to obtain new outside financing, and how long will it take to do so?
- Will the company be able to recover at all?
To the extent that the answer to some or all the questions show increased risk, the business valuator can increase the Company Specific Risk factor (and therefore, decrease the capitalized value of the company).
The business valuator can also adjust the long-term expected growth rate for similar factors based upon similar questions regarding the company, the industry, the United States economy and the world economy. However, remember that this is the long-term expected growth factor – if the company/industry/economy is expected to recover within the next year or so, the reduction in the long-term expected growth factor may not be significant.
If the company does produce forward-looking financial projections, then the business valuator can use the Discounted Cash Flow (DCF) method to value the business under the income approach. However, there are several caveats which must be followed:
- The business valuator may not be involved in any way in the creation of the forward-looking financial projections. Otherwise, the business valuator’s independence is impaired.
- The company cannot “game” the system by retroactively creating forward-looking financial projections. For example, if in March 2021, the company needs a business valuation with a valuation date of June 30, 2020, it cannot create forward-looking financial projections at that point. Instead, it can only use forward-looking financial projections which had been created as of the June 30, 2020 valuation date.
- The business valuator cannot accept the forward-looking financial projections “as is”. He/she must test the reasonableness of the underlying assumptions which went into creating the financial projections (for example, if the business is a dine-in restaurant with a valuation date of June 30, 2020, and restrictions on dining in were removed on June 30, 2020, the valuator must consider the reasonableness of projections showing either a return to 100% of pre-pandemic operating levels within 30 days or a projection showing no sales revenues for the next year). Because something must be known or knowable as of the valuation date (which in this example is June 30, 2020), the business valuator cannot consider using actual operating results from July 1, 2020 to February 28, 2021 as a reasonableness check, since those actual operating results were not known or knowable at June 30, 2020.
As with the Capitalization of Earnings method, the business valuator can also adjust the Company Specific Risk (or Equity Risk Premium) and long-term growth rate in calculating the value under the income approach. However, the business valuator must make sure that these adjustments do not duplicate the assumptions which the company used in creating its forward-looking financial projections or else it will “double” the impact of the adjustments.
If you require the services of a Certified Valuation Analyst in Philadelphia or any other forensic accounting services in Philadelphia and the Delaware Valley, please contact the Philadelphia forensic accounting firm of David Anderson & Associates by calling David Anderson at 267-207-3597 or emailing him at david@davidandersonassociates.com.
About David Anderson & Associates
David Anderson & Associates is a Philadelphia forensic accounting firm that provides a full range of forensic accounting services in Philadelphia and the Delaware Valley. The experienced professionals at David Anderson & Associates provide forensic accounting, business valuation, fraud investigation, fraud deterrence, litigation support, economic damage analysis, business consulting and outsourced CFO services. Company principal David Anderson is a forensic accounting expert in Philadelphia who has more than 30 years of experience in financial and operational leadership positions and is a Certified Public Accountant, a Certified Valuation Analyst and a Certified Fraud Examiner in Philadelphia.
