Financial forecasting is complex at the best of times, but the current level of economic volatility and the consequence of Russia’s war in Ukraine is undoubtedly going to make it even tougher.
Usually, an important element of the valuations process is a review of historic performance figures. But that approach has become less reliable, given recent business disruption. Meanwhile, benchmarking pricing metrics has become more complicated, as myriad operating and financial challenges faced by companies over the past few quarters have impacted various sectors – and different businesses within those sectors – in very different ways.
The effect of any short-term COVID-19 support creates further complexity that also needs to be understood and taken into account. “Adjusting for COVID-19 in private companies has been tricky because there are simply not the public company comparables,” says Michael Weaver, valuation services managing director at Kroll. “Revenue multiples have long been used for venture and there are other metrics that go back to the dotcom boom. I hesitate to say it’ll be easier to value companies, but there’s more and better and richer data.”
Jim Davies, an FRP Advisory corporate finance partner and valuations specialist, suggests that we’re now in a recovery phase of the economic cycle, but against a backdrop of rising inflation and pressure on interest rates. This makes valuing companies, assets and investments far more involved than in a stable market.
The road to recovery
“Valuation multiples vary widely at the moment as companies follow very different recovery paths,” he explains. “There’s an absence of recent transactions in certain industries, so a lot of care and attention is needed in price benchmarking. It’s really important to understand the advantages and drawbacks of different valuation approaches and to adapt techniques and methodologies to become more suited to the current climate.
“When the pandemic hit, many companies initially focused on conserving cash, for example, so real care needs to be taken to understand their near-term cash requirements to catch up, adapt and reposition for growth. This goes for operating costs, as well as investment in working capital, capital investment, R&D and so on.”
With low interest rates (for now) in a climate of economic, industry- and company-specific risks, traditional ways of assessing the cost of capital must be treated with caution, too. The Russian invasion of Ukraine and how that has rippled – or ripped – through certain economies will also have a major bearing on cost of capital judgements.
“Valuations feel, frankly, a little bit toppy right now,” says Weaver. “I think there’s going to be a correction at some point. We’re starting to see some restructuring. But private equity still has a lot of liquidity available and our private equity clients don’t think multiples are necessarily going south quickly because they can’t get into any deals right now. Available cash might trump the headwinds of inflation, interest rates and more general nervousness about valuations.”
Cash-rich corporates
The amount of cash looking for a home is really driving prices, argues Doug Lawson, CEO of MarktoMarket, an M&A data and analytics business and a member of the Corporate Finance Faculty: “Private equity is sitting on about $2trn of dry powder. But another big number is the amount of cash on UK corporate balance sheets. In 2020, [UK corporates] decided to batten down the hatches and build up cash. That now has to be invested, deployed or paid out as dividends. So you have private equity money and corporate money.”
MarktoMarket publishes an all-cap index for deals valued at less than £250m, involving any UK company. Last year, it stood at 9.9 x earnings before tax, depreciation and amortisation, up on 9.5 x earnings before interest, tax, depreciation and amortisation in 2020.
“Again, 15 years ago, it was high-street banks lending to UK corporates, but now you’ve got a long list of alternative lenders,” Lawson adds. “There’s a huge amount of cash looking for investment opportunities in a low-growth environment. That’s a big driver of multiples.”
Weaver wonders if funds will be flexible: “Are they more likely to settle for discounts to sell a portfolio than banks? That has not been road-tested over here yet. Banks, perhaps because of COVID-19, have been reluctant to push the button on companies, but that may start. There are a few zombie companies that need restructuring.”
The increasing use of buy-and-build as a private equity strategy is also driving up multiples in the lower- to mid-market – multiple arbitrage can be achieved through simple change of ownership. Lawson explains: “That’s pushing up the price of small businesses, particularly in industries that are consolidating fast, because you’ve probably got three or four consolidators all after the same asset.”
Transaction multiples at an all-time high and cost of capital at an all-time low are driving the prices being paid, says Hanut Dey, a valuations director at Eight Advisory. “This hints at the high amounts of capital available to be spent as levels of dry powder continue to grow. I think this is driving the divergence between value and price that’ll continue to create both challenges and opportunities for valuation professionals in 2022.”
Keeping it private
Lawson points to another megatrend – movement of capital from public to private markets: “More asset allocators are allocating more of their pot to private markets. Companies are staying private for longer to benefit from the appreciation in value that comes from that early- to mid-stage of growth. Previously, high-growth companies were far more likely to tap public markets earlier and raise capital for growth. They’re doing that less frequently because capital is available privately. They can avoid the level of scrutiny and the additional work that you have to do as a public company, and the distraction of the city.”
Traditionally, one advantage of being public was that profitable businesses could tap public markets for capital to make acquisitions. But public markets won’t fund losses. “Private capital and venture capital is more patient and understands the whole story about funding losses effectively to propel top-line growth,” Lawson adds.
That said, the high-profile floats of electric vehicle makers Lucid Motors, on NASDAQ via a special purpose acquisition company in July 2021, and Jeff Bezos-backed Rivian (also on NASDAQ) in November 2021 raise fundamental questions about value and pricing. On listing, they were valued at $24bn and $65bn respectively.
One factor driving Rivian’s listing value was a single order for 100,000 delivery vans from Amazon, which is also a shareholder. Davies says: “It would be fascinating to know what assumptions investors made around Rivian’s long-term share of the global auto market. It’s a business with virtually no revenue or production capacity and only a few orders, yet the IPO briefly valued it at over £100bn – more than Honda, Ford and General Motors.”
The established companies may be less advanced in certain technological areas, but they’ve spent decades mastering mass production, delivering huge volumes of numerous models. The automotive sector is incredibly competitive and almost all players are moving towards electric.
“There’ll be a few successful new players, but when we’re fully electric it’ll remain a fiercely competitive market,” says Davies.
Price vs value
How can a company with no discernible earnings and brand-new operations be worth more than mature companies with revenues in the billions? If we suspect that the implied market share is too ambitious and the challenges to reaching super-efficient volume production are understated, to what extent is the current value supported by investors’ genuine belief in the underlying fundamentals, and will its share price rise? Or how far has price diverged from value?
“It’s very often a dynamic around big tech-driven IPOs,” says Davies. “Similar questions have long been asked about Tesla, now valued at over $1trn.
Dey concurs: “With the cost of capital currently so low, the value of longer-term future earnings has more of an impact on the current value, so investors may be willing to overlook near-term losses if they expect the company will ultimately dominate the electric vehicle market.”
The challenges mentioned above highlight the potential risks in automating the valuation process and there is a range of views about that.
Davies says: “In a very stable market, it’s tempting to think that automating valuations is doable, but as soon as stability falls away, the idea seems farfetched. So, while there’s a place for technology in the valuation sphere, and AI and machine learning should be part of that, we need to be careful about how far that goes.”
Integrating AI and machine learning into the overall delivery of valuations has its attractions and these technologies are developing at a rapid rate.
Dey says: “The end benefits are clear to see, but consultants are usually not the first adopters of any new technology. However, it just needs a professional brave enough to jump first and then the rest can learn from their initial mistakes.”
Tech takeover?
Davies, however, sees valuation as a fundamentally human process that tech cannot replicate: “Value depends on what the market is willing to pay. In the absence of genuine market testing, a valuer’s role is essentially to mimic the process investors would go through when pricing a target in order to provide an estimate of market value. If human beings are driving investment decisions, then they should be driving valuation decisions, too.”
The onward digital march is inevitable, offering valuers a wealth of data, although of varying value. “Valuation professionals shouldn’t be worried about being replaced by robots,” says Davies. “While the technical side can and should be supported by technology to drive consistency and efficiency, the commercial reasoning requires a blend of experience, discussion, commercial awareness, challenge, reasoning and articulation that only human intervention can provide,” he says. The growing role of technology should free up valuers to work on the more complex and subjective elements of valuations.
