Ask the Expert with Steve Plaskitt – the impact on company valuations following the pandemic

The valuation of a business is an art rather than a science but the unprecedented months since the Covid 19 Pandemic started have created a long-lasting impact on SME company valuations.

Public markets initially saw huge falls with stock prices dropping up to 25% in the first half of the year before recovering and we may expect to see a few more bumps in the coming months as the true long-lasting impact of Covid 19 becomes apparent. SME company valuations have been similarly impacted.

Typically, SME valuations are based on three factors: the historic earnings, the asset values, and the future earnings; and sometimes a combination of all three are used to arrive at a valuation.

The historic earnings-based method applies a multiple to past profits – using earnings before interest, tax, and depreciation (“EBITD”) as a way to represent the recurring cash profits of a business. Adjustments are made for the cash and debt in the company at the time of the valuation. Sometimes a weighted average of the last three years profits is used as this is a simple way to eradicate the performance of a one-off year. The multiples used to apply to these profits may vary from industry to industry with software companies rich in intellectual property and recurring revenue sometimes having multiples of over 20 times EBITD, whereas more traditional sub-contracting businesses with few long term contracts may have multiples as low as 3 times.

The asset-based method – adds an estimate of goodwill to the balance sheet’s net asset value to arrive at the valuation of the company. This is the value of one year’s historic EBITD represents the value of that goodwill. This method is often used where the net asset values are relatively high and the profits are relatively low, perhaps because the business is capital intensive.

Often for fast growing businesses, the valuation is based on future earnings and estimates are based around the financial projections and forecast models. This is used for those businesses where there has been a step-change in the business so that the historic revenues will not bear resemblance to the future revenues – perhaps because of a large investment or perhaps due to the one-off impact of a significant event, such as the Pandemic.

And this is how the impact on valuations for SMEs will be felt for many years to come.

For many businesses, the impact on weighted average historic profits and so their valuations will currently show a 25% fall in values – as was initially seen in public markets. Over time the impact of this diminishes and for example, after two more years the impact may be around 8% which would still represent a significant fall in value for many businesses’ owners. This position may be worsened if the businesses has suffered losses and has had to take on more debt recently such as the Government’s Coronavirus Business Interruption Loans.

So as an SME business owner how do you maintain your value and get your valuations higher?

The answer is simple to explain but harder to achieve in reality: it is to increase shareholder value, to persuade the buyer that there has been a step change in the business and that the future earnings method is the most appropriate way of valuing the company. This may come through new management, innovation, developing new technology, improving your competitiveness, embedding recurring contractual revenues into your business, or finding new markets for your products and services.

The ways to achieve these answers will be different for each business, and an experienced corporate finance adviser can bring a lot of value to the process of helping the shareholders and directors to understand their unique valuation drivers and to develop their financial forecasts, and so contribute to the business growth or the shareholders exit strategy.

The sooner a vaccine can be found, the sooner herd immunity can be established, and we can start to live our lives fully again. Realistically, SME company valuations are not yet immune to Covid 19 and business owners who innovate will ensure that they can change their business and continue to grow shareholder value.

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