Weathering the storm created by Covid-19 has a different connotation for all businesses, particularly for financial reporting professionals when managing balance sheet requirements, disclosures, and shareholder communications. In volatile times, business valuations and impairment testing require a clear understanding and precise application of valuation principles and methodologies to analyze the market disruption impacts on a company’s assets, including potential goodwill impairment.
By relying on facts and fundamental data, we provide our observations through a valuation expert’s lens and measure how Q3 2020 events have impacted equity market indices, adjustments to EBITDA expectations, and their influence on enterprise values by sector.
Most sectors showed a more substantial decrease in the next 12-months (NTM) EBITDA than a decline in enterprise values for Q2 2020. We believe this indicated an increase in market multiples, which were challenging to reconcile in the current environment. A more reasonable conclusion for many companies was to view 2020 as an anomaly, with businesses expected to return to normal levels in 2021. As a result, the impact on enterprise values had not been as significant as nearterm expected EBITDA.
For Q3 2020, material increases to NTM EBITDA for all the industry sectors combined with moderate increases or even decreases to a decline in enterprise values have resulted in lower EBITDA multiples for Q3 2020 relative to Q2 2020. The increases to NTM EBITDA also seem to support the conclusion that many companies view 2020 as an anomaly, with businesses expected to return to higher levels for 2021. However, given the uncertainty of the pandemic’s future economic effects paired with the timing of vaccine development, uncertainty regarding the second round of government stimulus, and the presidential election, there is a material risk to forecasts.
What Does This Mean for Business Valuations and Impairment Testing?
From a market approach perspective, most sectors indicate that the enterprise values are slightly lower for the Q3 2020 relative to the 2019 calendar year. In the context of the income approach, we anticipate nearterm expected cash flows to be materially lower, and there may be significant risk associated with expected earnings beyond 2020. There are many different subsectors within the 11 sectors we cover here that may have varying results relative to their overall industry.
The SEC is making it a priority to focus on impairments related to Covid19. In Q1 and Q2 2020, while many companies may have concluded (and reported) that, despite rapid changes in their stock price and uncertainty about the shape and timing of a recovery, it is unlikely that goodwill is impaired. For many companies, their analysis was a simple comparison of their market capitalization and the book value of equity without more than a cursory review of individual reporting units, given the rapid nature of the downturn and the potential for varying outcomes. The SEC is now asking for a more detailed analysis regarding impairment disclosures.
VRC remains of the opinion that more than likely, Q3 2020 financial evidence will show that many companies will require interim impairment testing, and the effects on accounting and valuation issues may further evolve before coming to a final resolution.
General Market Event Observations
Through the first half of 2020, the market experienced significant volatility and significant swings in equity market indices. In mid-February 2020, all three major stock indices of the U.S. equity markets (Dow Jones Industrial Average, NASDAQ Composite Index, and S&P 500) reached all-time highs. However, in late February 2020, stocks began to plunge into correction due to coronavirus fears. Stocks continued to decline as the World Health Organization declared Covid-19 a pandemic on March 11, 2020, and on March 13, 2020, Covid-19 was declared a U.S. National Emergency. All three major stock indices reached new lows on March 23, 2020. Since that time, all three major stock indices have experienced monthly increases through August 2020.
By the end of August 2020, the NASDAQ and S&P 500 indices were higher (19.9% and 3.4%, respectively), and the Dow Jones index was only slightly lower (3.1%) than back in mid-February 2020. At the end of Q3 2020, all three major stock indices finished lower for September 2020, the first monthly decline since March 2020.
The significant government assistance programs like the CARES Act and Paycheck Protection Program (PPP) appears to have supported the markets as they rebounded from substantial declines. With the CARES Act’s expiration on July 31, 2020, and PPP expiration on August 8, 2020, will the market be able to support current levels without these government assistance programs? President Trump authorized the creation of the Lost Wage Assistance (LWA) Program to replace the Federal Pandemic Unemployment Compensation Program created by the CARES Act but at a lower level of unemployment compensation. By the end of Q3 2020, the Senate and House of Representatives could not agree on legislation for the second round of stimulus. Concerns over the timing and amount of stimulus and uncertainty on the upcoming presidential election outcome finally began to weigh on the stock market indices in September 2020.
The chart illustrates the Q1 2020 significant decline from CY 2019, and the material rebound from Q1 2020 to August 2020 month end for all three major U.S. stock indices. From August 2020 month end to Q3 2020, all three major U.S. stock indices were down. The Dow Jones Industrial Average was down 2.3%, the NASDAQ Composite Index was down 5.2%, and the S&P was down 3.9%.
As illustrated in the chart, material decreases in NTM EBITDA forecasts from the CY 2019 to Q2 2020 as EBITDA expectations had been adjusted to reflect Covid-related impacts. As expected, the most significant declines to the forecasted NTM EBITDA are for the energy and consumer discretionary sectors. The reduction in the forecasted NTM EBITDA from CY 2019 to Q2 2020 for the energy and consumer discretionary sectors are materially higher than decreases observed for the change in enterprise values from this same period.
There has been a material change in NTM EBITDA forecasts from the Q2 2020 to Q3 2020 as the economy began to recover slowly, businesses started reopening, and unemployment trended downward during this period. As shown in the charts, all industry sectors have increased NTM EBITDA forecasts from Q2 2020 to Q3 2020. This is a material rebound from the lower NTM EBITDA forecasts at Q2 2020 relative to CY 2019.
As shown in the chart for the change in NTM EBITDA forecasts from CY 2019 to Q3 2020, most industry sectors NTM EBITDA forecasts as of the Q3 2020 are within 5% of the NTM EBITDA forecasts as of CY 2019. Not surprisingly, the three industry sectors with NTM EBITDA forecasts as of Q3 2020 that are materially different (more than 5%) than the NTM EBITDA forecasts as of CY 2019 are energy, industrials, and consumer discretionary.
In early 2020, global energy investment was on track for a 2% growth, which would have been the most considerable annual spending rise in six years. But after the Covid crisis brought the world economy to a standstill in a matter of months, global energy investment is now expected to plummet by 20%, or almost $400 billion, compared with last year, according to the International Energy Agency’s World Energy Investment 2020 report. Summer is peak demand months for driving; however, the summer of 2020 saw low demand with limited travel, and many people still working from home. Despite the declining trend in crude stockpiles in the U.S., inventories are still highest seasonally in more than a decade per Energy Administration data. These factors have contributed to the significant change factors in NTM EBITDA for the energy sector.
The Industrials sector has suffered significantly from the global economic recession, with industrial output faltering as a manufacturing downturn has broadened globally. While defense spending is likely safe, the sharp retrenchment in the economy and travel has weighed on airlines and the transportation industry in general.
Consumer behavior has changed in response to the pandemic, which negatively impacted the consumer discretionary sector. However, some sub-sectors like home improvement and online retail have been positively impacted. Due to record declining levels of unemployment and incomes, consumers spend on essential, not discretionary items. As businesses reopen, many are doing so with much less capacity to adhere to social distancing guidelines. Yet many consumers remain reluctant to return to daytoday activities outside their homes without medical endorsement or the development of a vaccine. The Q3 2020 period saw a declining trend in unemployment and more consumers returning to day-to-day activities, which led to a significant increase in NTM EBITDA forecasts for the consumer discretionary sector from Q2 2020 to Q3 2020.
The majority of the sectors have experienced a decrease in enterprise values from CY 2019 to Q3 2020. The decline in enterprise values from CY 2019 to Q3 2020 for the energy sector was materially more significant than observed for the indices and the other sectors. The energy sector continues to face heightened uncertainty due to the massive supply/demand imbalance perpetuated by the Covid-19-related economic shutdown. While most of the sectors experienced a decrease in enterprise values comparable to the declines observed for the major U.S. stock market indices, the information technology, consumer staples, and utility sectors experienced an increase in enterprise values from CY 2019 to Q3 2020.
One interesting observation from these charts is that all 11 industry sectors had increases in NTM EBITDA forecasted from Q2 2020 to Q3 2020, while just over half (6 of the 11 total industry sectors) saw an increase in enterprise value over the same time. The rise in NTM EBITDA forecasted from Q2 2020 to Q3 2020 was greater than the increase (or decrease) in enterprise values for all 11 industry sectors. This implies that EBITDA multiples are trending lower from Q2 2020 to Q3 2020.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
Jason Mutarelli, CFA is senior vice president with VRC’s Yardley/Princeton office. He specializes in business valuations, valuations of intellectual property, and solvency and fairness opinions. He serves clients in most major industries. Jason can be reached at JMutarelli@ValuationResearch.com or (609) 243-7012.