Interchange July09: Valuation in turbulent times - Ernst & Young - United States

Valuation in turbulent times

Asset values have fallen dramatically over the past year. The perception is beginning to take hold that the bottom is near for prices. Still, except for certain industries, there has been only a minimal resurgence in M&A activity. A lingering credit slump is partially to blame. But another powerful damper on deal-making is the complexity and uncertainty of valuing assets/companies following a severe downturn.

Valuation is challenging in any market. But a host of factors from volatility in expected future cash flows to question marks surrounding coming regulatory actions are making a tough job even harder. Both buyers and sellers should be prepared to devote heightened levels of effort and due diligence when developing and supporting their valuation methodologies and results. In addition to using traditional discounted cash flow (DCF) techniques, those contemplating transactions should consider models that incorporate a wider range of scenarios for the individual inputs of any valuation.

Heightened risks
Among the issues complicating valuation and raising transaction risks are:

A dearth of comparables. Buyers and sellers generally look to the market to gauge whether a bid or offer represents a reasonable multiple of cashflows. With so few transactions taking place, executives have little to go on in terms of using comparables.

Economic uncertainty. As orders slow, more businesses are burning cash — and lenders are proving slow to provide any significant cushion. Meanwhile, major US stock index and valuations are down significantly relative to 18-month highs. As for daily trading, price movements of 3% to 5% or more are proving common-place in some markets. Economic and commercial uncertainty greatly reduces the reliability and therefore utility of historical sales, asset pricing and other components of valuation.

Regulatory activism. As if pricing wasn’t cloudy enough, markets are also faced with the unknowns associated with energy and healthcare reform. The introduction of a cap-and-trade environment or some other form of energy regulation will undoubtedly impact valuation for certain industries — in some cases profoundly. Companies will need to develop a range of scenarios — high, low and moderate — for the likely impacts of higher energy costs. Such analysis will need to evaluate the impact on not just the assets whose valuation is in question but also on customers, competitors, suppliers, partners and the economy as a whole.

The same is true of expected changes in healthcare provision and payment. Until legislative concepts become firm proposals, there is no way to accurately assign their costs or other effects. And this is to say nothing of impending challenges in funding for social security and Medicare.

Court oversight. Yet another complicating factor in today’s valuations is the prevalence of assets in bankruptcy. Though such valuations are based on free market evidence, ultimate decisions reside with a court. Such assets may also be subject to claims from other creditors or similar impairments — although if a buyer exercises great care in applying Bankruptcy Code Section 363, such risks can be reduced.

Valuation in a downturn
In essence, the economy is in largely unexplored territory, meaning executives must work that much harder to justify their bid or offer pricing.

For a buyer, the first principle is that more than ever, strategy should drive transactions. Take advantage of relatively low valuations, but stick with acquisitions that closely fit the overall strategies of your company. In other words, today’s market conditions are not the best place for speculative investment. Rather, the market should be viewed as an opportunity for consolidation.

Once an acquisition is under consideration, it will be important to go beyond traditional financial and operational modeling. Valuation approaches often rely on basic DCF models. However, with the unknowns in today’s marketplace, such models are subject to enormous interpretive variation. Consider virtually any term in a pricing equation — future sales, costs, taxes, interest rates, cost/revenue synergies; given all of the factors at play in today’s economy, executives would be challenged to certify the validity of their underlying assumptions.

A natural response is to lean toward more conservative estimates, with the models incorporating lower estimates for sales, higher assumptions for taxes or higher interest rates. In such cases, in spite of such relatively low asset prices, few if any deals may be able to achieve the required return.

Enter modeling 
An essential practice in volatile markets is to build a range of variability into assumptions. A basic means of achieving this might be to use a range of values for the various model inputs. For example, a company’s DCF model would be run using high estimates, low estimates and then expected estimates. The resulting range is the familiar worst case, best case, expected case analysis.

An even more sophisticated approach is to use a valuation model that builds variability of inputs into its fundamental design. Instead of using a discrete figure for sales, the model would show a range of sales figures along with their associated probabilities. Similar ranges would be developed for all principal variables, such as interest rates, competitor actions and the economy’s overall expected performance.

Now the model is allowed to run through multiple, often hundreds or thousands of iterations, each time generating a valuation based on the interaction of all of the ranges for the interconnected variables. Instead of a worst/best/expected scenario, such a Monte Carlo-style analysis reveals ranges of worst/best/expected scenarios along with their probabilities. Management will now be equipped with a fuller understanding of the economics of their prospective transaction.

On the sell side
The hard truth is that for most asset classes this is a buyer’s market. Clearly, if an asset isn’t a drain on cash flow or management resources, now may not be the best time for divestiture. But if the asset is going on the block, it will be important to understand the uncertainty faced by buyers and hence the tendency for relatively low bids.

To help overcome the forces driving valuations downward, sellers should arrive at the table equipped with their own detailed scenario analysis. The more detail that can be provided, the greater confidence a buyer will have that the seller is presenting a realistic appraisal of its assets’ likely future performance. It will also be helpful to provide the buyer with as much hard evidence as possible. For example, well-prepared carve-out financial statements can help clarify the unknowns tending to depress buyers’ bids.

Strategy trumps the numbers?
Of course, there is also something to be said for avoiding overreliance on models — executives often need to move fast and so must avoid “analysis paralysis.” If a transaction makes strategic sense, that might be a factor deserving heavier weighting. A thorough, scenario-based approach can lead to a meeting of the minds as well as to fewer regrets/surprises after the deal is done.

Valuations in emerging markets
Companies with strong balance sheets may view current conditions as an opportunity to acquire offshore assets. But every valuation challenge evident in today’s US markets applies overseas — and then some. Some of the special considerations and challenges include:

• Even fewer comparables as a result of less liquid markets
• Often excessive involvement of local governing/regulatory institutions
• Cultural differences contributing to operating complexity
• Currency risks
• Transfer pricing issues
• Country risks (expropriation, repatriation, etc.)
• Proposed changes in US tax law to make offshore earnings “currently” taxable

Rather than working from discrete values for the various pricing inputs, it will be important to use ranges and run multiple “what if” scenarios. Noting the added risks of offshore investing, the discount or hurdle rate for valuing such assets should be significantly higher than that used for domestic acquisitions. There are international opportunities, but investors should proceed with eyes wide open.