How Will the Recession Affect the Value of My Business?
Helen Mallovy Hicks
Ken Goodwin, a partner in the Dispute Analysis & Valuations group at PwC, sheds light on valuations and answers questions on how your business might be valued differently in a tight economy.
Dean: Welcome to Strategy Talks with Dean and Helen, part of the PricewaterhouseCoopers Managing in a Downturn podcast series. I'm Dean Mullett, co-head of our Restructuring and Distress Strategy Group, and a member of our Credit Crisis Task Force.
Helen: And I'm Helen Mallovy Hicks, a Partner in the Advisory Practice of PricewaterhouseCoopers in the Dispute Analysis & Valuations group.
Dean: The current state of the economy is understandably of great concern for most Canadian businesses. This series of audio podcast discussions with a variety of subject matter and industry guests are designed to help your business weather the storm by exploring some of today's hottest issues related to the economic crisis.
Dean: In today's episode of Strategy Talks, "How Will the Recession Affect the Value of My Business", we welcome Ken Goodwin, a Partner in the Dispute Analysis & Valuations group here at PwC. He will help shed some light on valuations and answer some questions on how things maybe be valued differently in a tightened economy. Welcome, Ken.
Helen: Welcome, Ken. How is an organization valued during recessionary times? Are there key differences?
Ken: Well it's an interesting question Helen. I'd say that in terms of how to value a business, nothing has really changed. You've only really got three approaches you can work with. There's the income approach, market, and the asset approach. But what's changed in this recession, particularly with the financial markets the way they are, is how you actually apply those different approaches, and I would say that in this environment it's much more complicated than it has been in the past. You know, take for example using a market based approach to value your companies. Last year you may have been able to find companies in your space, all the multiples converge nicely, things were making sense. In this kind of market you can see those same companies with entirely different multiples.
Things are moving in different directions and it requires you to get below the numbers and dig a lot deeper than you would have had to in the past. And it even may leave you wondering whether or not you can still apply those same multiples in today's environment, because it's producing an answer that doesn't make any sense. I would say, too that even with say a discounted cash flow, how do you come up with your discount right now? You've got very tight credit markets. In some cases, clients will tell you they can't even get bank financing. So how do you apply that kind of concept, in terms of coming up with a discount rate? How much debt is there going to be there, what's it going to cost, and frankly what's your cost of equity? Things are just way more complicated today.
Helen: Have you found discount rates are changing? Are they going up, are they going down, or different factors affecting different companies? What are you finding in terms of discount rates?
Ken: Well, generally speaking, I would say the expectation right now would be that all of the things being equal, discount rates are probably going up. And that's for a couple of reasons. One is, the cost of borrowing is that much more expensive, credit's tight, spreads are up, and related to that is the fact that companies can't get the same kind of leverage that they had twelve, eighteen months ago. So you've got fewer debt turns, tighter covenants, a lot less flexibility with the lenders and that obviously increases risk to a certain extent, but also just the magnitude of the discount rate.
And then at least on the cost of equity side, why you see some of the inputs maybe changing, generally speaking, the feeling in the market is that equity risk premiums have increase. So when you take all of these things together, it leads you to believe that without some really good evidence to the contrary, you're probably looking at higher discount rates today.
Dean: Ken, when it comes to valuation, a lot of people assume some type of permanence around it. So if you're a company today looking to transact, be it to sell a division or a non-core asset, or one that wants to buy, how do I go about getting a fair valuation today, and should I just be looking at what it's worth today? What it's worth coming out of the downturn? How do you really get your head around that?
Ken: Well, I think first and foremost, you've got to be hiring somebody who knows what they're doing, and who's in the business, and who understands I think both sides of the story (and that would be not only the seller's side, but also the buyer's side). The other thing, too, is if you are the seller, you've got to put all of the relevant facts on the table, and you really want to be playing up your relative strengths, compared to the other companies in your peer group, and if you can bring those forward and make those a good case in your valuation, then it's going to help you look, relatively speaking, better than your competition. Which, frankly, in this environment, may be the best that you can do. Because if companies have declined on an overall basis, but relatively speaking, you can bring those strengths forward, you may find that you're holding up a lot better than your competition.
Dean: I would assume then, that a buoyant transaction market, where there's lots of comparable transactions, it makes it easier to negotiate a fair valuation at any arms length transaction. But in times when there aren't a lot of comparables, I would assume then that relative negotiating abilities become a lot more important in establishing a valuation and supporting valuations in this marketplace.
Ken: Yeah, I mean there's no question. In our line of work, we would usually consider a transaction that's been done in the last twelve months as being recent. That was last year. This year it's probably zero to three months is still recent. So in the absence of those transactions, you are having to negotiate and you are having to point out to people that look, the recession is temporary. It's not going to last forever. We do need to look forward, getting part of your other question there, and look at how we're going to exit this in a couple of years. And play up those opportunities because otherwise you just get stuck in a quagmire.
Dean: That's an interesting point, the recession isn't permanent, and we sometimes forget that is the case, so it's always nice to find a little bit of a silver lining, maybe some optimism.
Helen: What valuation approach do you use to cross check your discounted cash flow approach and make sure the results under that approach are reasonable, given lack of market data?
Ken: Well, just thinking about the DCF for a second, you raised a couple of good points. One is you really need to be, I'll call it kicking the tires, on the forecast, and understanding whether or not it's going to be realistic. Does it stack up to research you can do in the industry? Does it stack up to where the market's going to be going in the next couple of years? And as I mentioned earlier, you've got to be looking at where the market's at, in terms of pricing the various elements of your cost and capital.
But assuming you've done all of that and you think your discounted cash flow makes sense, the thing that's still out there are public companies. And public companies may be trading at values that nobody likes, or values that are lower than last year, but I don't think you can ignore the market, and you do need to do that sanity check at a bare minimum and consider it as a real data point in your valuation exercise. Well that's what we're doing. We're taking whatever approaches we can get our hands on, and looking at whether the discounted cash flow on the one side, also looking at market comparables, and trying to, I can't say triangulate because the transactions just aren't there, but at least use two indicators to get a decent valuation.
Helen: And in some cases, given current market prices are so depressed, they may indicate a valuation lower than your coming up with in your DCF approach, even after you've kicked the tires. What kind of things are you finding that make up that reconciliation between the market value, based on a trading multiple, and the discounted cash flow approach?
Ken: Well one of the things that we have seen impact valuations of public companies is leverage that maybe within that public company. The equity markets are really penalizing companies with too much leverage these days.
Dean: Right, and the risk model is so...
Ken: Yeah the risk model now looks like it's out of whack, and you have your fixed operating costs are extremely high because of all of the debt and the debt servicing requirements. So those types of companies are really seeing a diminution in their value. And I think on the other side of the story, with respect to a discounted cash flow, it's possible that the discount rates in the forecast just aren't meshing up. But you really don't have enough of a risk factor built into your discount rate to try and corroborate what you're seeing in the public markets.
Dean: So, Ken it must be heady times to be a business valuator today. Very overwhelming with lots of work, lots of opportunity. The press is full of companies that are taking acid write-downs and things of that nature. Clearly valuations play a big part in that. Maybe give us your perspective on that.
Ken: Well, there's no question, Dean that the last three or four months have been unprecedented in our practice. We're working with both non-audit clients as well as our audit clients assisting them through their year-end process, and the number one question on the books for many of our clients is, "What's the value of goodwill?" Particularly with public companies where you can see that the share price has dropped below the book value per share. That's the number one question. And there's an unbelievable amount of effort being put forward into looking at what is a credible fair value, and when you bring fair value into the equation, you are now dealing with all the intricacies of the accounting, whether it's Canadian or even US GAAP. And coming to a conclusion that's going to be supportable is first and foremost on everyone's minds.
Dean: That must make for some challenging discussions when people have different opinions on what value may be. And having been in the corporate finance world for years, I know as many people are in a room — as many opinions there is on value.
Ken: Well it certainly is, and valuation is a matter of judgment, and as you put it, two corporate finance professionals, or two valuators are going to have a different opinion. I think what we try to bring to the table is a level of pragmatism: let's look at the facts, let's see what evidence is out there, and we have to make a decision based on the evidence that's there. Whether we're in an audit capacity, or whether we're trying to put forward a valuation report for a non-audit client, because at the end of the day, it has to pass the same test.
Helen: Ken, how on the non-audit client side can we help our clients with their financial statement, goodwill valuations?
Ken: Well I think the number one thing we can bring to the table is our experience and our credibility, and the way that we go about looking at the issue. We take into account our clients' views on value. We get in there, we understand their business. But we also look at what the market's saying, and you have to be able to blend those and reconcile those, because often the views can be contradictory. At the end of the day what we produce is a credible report, and it stands up to the test of the other auditors, which is what our clients really need.
Helen: Ken, do you want to give us your 30-second elevator pitch?
Ken: Why PwC? Well I think we bring a combination of very deep, functional expertise. It's matched by great industry experience, and we take into consideration all of the relevant factors, not the least of which is our clients' views on value, and we reconcile that with all of the other evidence that is available and that we can bring to the table. And at the end of the day, what we produce is a credible report, it's well reasoned, it gets to the point, and it gets through the test of other scrutiny. And last but not least, I think what it does do, is allows management and boards of directors to make well-reasoned and sound business decisions.
Helen: Now Ken, I think we're almost out of time. With our few remaining moments, is there one piece of advice that you could leave our audience with, and if there is what would that piece of advice be?
Ken: Well I think regardless of the market, valuations are judgmental, and are complex exercises. But with this recession, combined with the tightness in the credit markets, it's even more so, as we've talked about over the last ten minutes. And I think that what people need, they need to bring an experienced Firm to the table, like PwC, who's in the trenches. Who see the issues. Can look at various perspectives and look at the market evidence, have access to the research, and bring forward a credible and a well-reasoned valuation at the end of the day, because the worst thing you can do is put a number blindly out there, get it shot down because then you lose your credibility.
Dean: Great, thank you, Ken for your insight and commentary and practical advice for our listening audience. That concludes this episode of Strategy Talks, with Dean Mullett.
Helen: And Helen Mallovy Hicks. And you can find more about the effect of the current economic downturn on valuations and goodwill impairment, financial statements, by visiting the PricewaterhouseCoopers Managing in a Downturn webpage at pwc.com/ca/managinginadownturn.
Voiceover: In the next episode of Strategy Talks, Why Cash Is King, Helen and Dean talk to Calum Semple, co-leader of PwC's Restructuring and Distress Strategy Group, on the importance of liquidity in these tough economic times. Here's a sneak preview of what Calum has to say.
Calum: But we are starting to see cracks appearing where company owners, or company management are starting to realize that maybe something's not right, and if they start doing something now to sort themselves out, that they can live through the next few years.
Dean: This concludes this episode of Strategy Talks, part of the PricewaterhouseCoopers Managing in a Downturn podcast series. I'm Dean Mullett, thank you for listening.
Helen: And I'm Helen Mallovy Hicks. We hope you'll join us again soon for another episode. To download or to subscribe to this podcast series or to find more information on this topic, please visit our Managing in a Downturn website at pwc.com/ca/managinginadownturn.
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