BUSINESS VALUATION IN UNCERTAIN TIMES
There is a magazine for everything including family law and today I watched a brief video published in late May by Family Lawyer Magazine. The guest interviewed was Jay Fishman of Financial Research, a business valuation company headquartered just outside Philadelphia. Fishman is among the deans of that vocation so when I saw an interview about current trends in business valuations, I thought it 15 minutes well spent. The interview is here:
As Jay observes at the outset, business valuation is a process by which we take current data about a business and try to predict its future value. We have now almost all lived through a financial cycle where predicting the future seemed almost impossible, but the leading examples are the debt driven collapse of securities values in 2008 and the pandemic flash crash of 2020. While fast action by the Federal Reserve and Congress in both instances saved the economy in both 2008-9 and 2020-21, the latter recovery has sparked inflation that has made for a very wobbly securities market so far in 2022. In the 1970s we endured stagnation and inflation. Today the inflation is certainly there but the jobs market is one which can’t really be explained. The Fed is trying to dampen inflation with interest rate hikes but that has caused a lot of start ups launched in the boom economy of 2011 to 2020 to either collapse or run for cover by shedding jobs. Other companies, with deep pockets have embarked on buying sprees. Amazon has long been sizing up entry into the health care business. This week they forked over almost $4 billion in cash to acquire One Medical, a primary care network. The price it twice what the market thought the stock was worth the day before Amazon announced the acquisition. The health care industry has been watching Amazon for some time now to see where the giant would put its toe in the water.
If there was a central point to the Fishman interview it can be summed up as: the best valuations are done when the valuators know the industry and trends in which the company competes. Just about anyone can “run numbers” and arrive at a business value. But Jay noted that to prevail in a valuation case an expert needs not only to understand the economic environment which the target business navigates but to be able to explain that to the person or persons who are charged with deciding which valuation should prevail.
In these cases, the rubber hits the road when it comes time to assess the capitalization or discount rate. There are several elements to this four-part test that have been quite volatile so far this year, not the least of which is the risk free rate of return usually derived from 20 year treasury yields. A year ago, that number was about 1.8%. Today it’s 3.27%. So, if you are sitting on a six month old valuation, your risk free analysis is going to be “off” and needs to be updated, producing a lower business value. You then add to that the equity risk premium which involves comparison of returns on equities with returns on government debt. A year ago, S&P 500 sat at 4,500; today just a tad over 4,000. Most investors are today finding equities to be overpriced even after their 11% haircut this year. Then there is the size premium. Smaller companies typically have less cash and less flexibility when borrowing. A buyer of a small company wants a higher return because of the risk that the company won’t survive a bad economy. Some big fish have appeared on the beach since 2020 demonstrating that size does not always insulate larger companies from cash crunches. Revlon filed for Chapter 11 in June. Penneys, Neiman Marcus, and Brooks Brothers had preceded it. Some of those appear pandemic casualties but there is little question but that retail as we have known it remains in a state of flux; and those listed companies were supposed to be the deep pockets.
The related subject is specific industry risk. Three years ago a share of Carnival Cruise Lines would have cost you $60 or more. Covid effectively closed the business driving the stock to $12. Last summer when we thought vaccines were defeating Covid the stock climbed back to almost $30 but Covid variants, unrest around the world where cruise ships travel and rising costs for fuel have taken the stock under $9; 25% lower than the stock traded when the boats were forbidden to sail. Meanwhile Marriott is trading higher than it was before the pandemic and Hilton has “taken off” while airline stocks struggle with service reliability and fuel prices. The pandemic drove General Motors to $20 but by January 2020 it had tripled off that low. Alas, the Fed’s interest rate advances and Putin’s effect on gas prices have taken GM down by almost half in the last six months. Meanwhile Tesla has gone from $96 to almost $830 during the same period even though raw lithium prices have increased faster than oil prices.
The market isn’t always rational but it is always in motion and if your are working on valuing a business both you and your expert need to follow the bouncing ball. If you don’t, the valuation in your file risks becoming stale and looking dated or perhaps even stupid.
