Covid valuation

In this article we would like to explore how some of the variables change during this pandemic and how they will affect the company valuation. Also we have few guidelines for the company management how to be prepared for the recession.

Non-linearity in the factors contributing to valuation (especially during this [PH2] crisis)

Imagine you are building a castle of sand in a beach. You keep adding sand to the castle and it gets bigger and taller. When it doesn’t fall, you get even more confident and build it even bigger. At one point you just need to keep a single grain of sand on top of the castle to bring the entire castle down. What does this mean? Does this mean that the single grain of sand was responsible for the failure? No. It is the cumulative weakness of the structure that has been increasing from the beginning of the development of the castle. This is an example how different variables will have a nonlinear impact on the outcome.

Now imagine you are the CFO of a company (while economy is robust and growing) and you started to increase the leverage of the company and that lead to increase in the ROE (higher Debt/Equity leads to higher return of equity). You get even more confident and increase the leverage even further leading to more ROE to the shareholders. You will be rewarded for this and you keep increasing this until a point when a crisis strikes and the entire company defaults or go into huge loss and you might blame it on the external financial conditions and the markets. But in a way it is the weak capital structure of the company that is responsible for the collapse. Thus many of the factors which we feel actually drive the value of the company may not be drivers of value at all conditions.  Or in other words the factors have got a non-linear influence on the value (which we know but ignore at times)

How the investors look at value during this crisis?

Here are few of our thoughts about how investors view the company.

1. Shift towards liquidation value and book value based methods

Many of the assumptions and methodologies of valuation of the companies will become meaningless during this crisis. Broadly valuation can be done on the basis of two philosophies:

  1. Value on the basis of future events (assumptions of growth, future profitability using DCF, FCFE, FCFF etc)
  2. Value on the past performance/data and the current balance sheet strength, liquidation value (the cash , current assets, book value, net asset value etc )

Any value of the asset is the present value of its future cash flows. Hence the first method sounds very logical and accurate. But the probability of getting the value right is less. So the trade-off will be between a value of X (first method) with a very low probability Vs. value of Y (second method) with a high probability. Or in other words the first method will have a wide range of values (very wide to the point of no practical use at times) while the second method will give more definite value which we can use.

This is important from the perspective of the company because the goodwill and intangible mostly reflect the assumptions we make about the future prospects and may not hold true every time. This is especially true during the current crisis when the level of uncertainty is so high and any amounts of time spend in estimating assumptions is meaningless.

The second method will work even under crisis, bankruptcy or liquidation of the company. This brings us to the importance of value method of investing especially during the crisis.

2. Shift in the focus from P&L to balance sheet

When the economy is booming and growing steady the entire market will focus on the growth assumptions and the P&L of the company because that is what is driving the value (drives the market value not the intrinsic value). However during the crisis there are many variables which will directly impact the balance sheet without flowing through the P&L. This will not impact the ROE or profits, but impact the book value per share. While this give an inflated picture of the earnings of the company the underlying value of the company will be impacted.

Companies which have operations in multiple geographies and that have grown by inorganically by acquisitions might be sitting on significant goodwill which may be impaired in the coming quarters. This adds to the existing stress to the balance sheet of the company.

For the financial firms this can lead to breach of regulatory capital norms (solvency ratios) leading to raising of new capital.

3. Shift in thinking of investors: What can go right? Vs What can go wrong?

These are the two kinds of question most of the investors ask. What can go right and what can go wrong. The market returns may become asymmetric[PH3]  during a crisis. This means that the loss in a bad event is many times greater than the profit in a good event. Even though the probability of a bad event is less the outcome of a bad event is huge. Thus the expected loss will be high. (Expected loss = Probability of the loss X Loss given the event happened) This can be seen from the chart of the probability distribution shown below. During a normal period people may mistake this for normal distributions while in actual case it may not be symmetric as shown in the chart below.

A black swan event means high expected loss which the market may not consider under normal circumstances

Our estimates

Usually most of the investor looks for what can go right. But it is even more important to ask what can go wrong. This is because of two reasons

  1. The downside of something going wrong would be far greater loss then something going up.
  2. The other reason is that if we take care of the downside the upside will automatically be taken care of by the market as and when the market improves.

Because of the asymmetric distribution with fat tails in the lower end of returns we have to calculate the expected loss value rather than the probability of the black swan event. These are the kind of events which the market fails to price in or ignore.

Steps we can take during the crisis to emerge stronger

So how is this crisis different from the previous 2008 credit crisis? Most people attribute this as a recession or crisis as part of the cycle. However this is not part of a cycle of boom (Capital is plenty) and recession (Capital is scarce) in the economy. This is an external event something like an asteroid striking the earth.

As Howard Marks of Oaktree capital says in his memo dated 11 May 2020 (source: https://www.oaktreecapital.com/docs/default-source/default-document-library/uncertainty.pdf?sfvrsn=0), we are not sure of many things.  We are not sure of:

  • When can we get a successful effective vaccine?
  • If we are ready with vaccine how long it will take to immunized everyone?
  • If immunity doesn’t last do people need to get vaccinated regularly?
  • Will social distancing delay the herd immunity and thus delay the economic recovery?
  • Will the people who already recovered develop immunity?
  • And if immunity is developed how long the immunity last?
  • Will the virus mutate and the immunity covers all the new forms?

One more difference of this crisis (Vs other crisis like the 2008 credit crisis) is that this crisis will create a new normal and a new style of customer behaviour, human interaction and working culture. This new normal is going to stay with us even after the vaccine is developed.

Why is the stock market (Benchmark indices) not impacted even in the midst of crisis?

Even with a large percentage of the working population in the US not working (high unemployment and lockdown), the benchmark has not dropped as we would have expected. This is mostly driven by the increased spending of the governments all across the globe and we know that this can’t be kept at inflated levels for long.

Due to the actions of the fed the interest rate will remain low for some time. This will mean that the future cash flows will be discounted at lower interest rate which will lead to higher asset values. This is one of the reasons why the asset prices have not reduced. However the artificial lower interest rate (by lending cheap using tax payers money) is not sustainable because ultimately the governments have to give preference to the ‘main street’ than the Wall Street.

Dow Jones Industrial average is now almost back at the level of October last year

Source: Bloomberg

Due to this paradox, at least few investors are having a false sense of security that the economic recovery has started.

What actions are to be taken by the company management?

We have few recommendations for the company management. However the most optimum course will vary from company to company.

1. Preserving cash

The company has to find ways to preserve cash. This can be done either by reducing cash burn or by monetizing the non-strategic assets. This is to protect the company from any liquidity crisis arising from the default of customers or any other counterparty risks.

Having cash is a strategic advantage during the crisis since that will enable the company to focus and spend on the important things needed (say for example not to cut down on the R&D expenses or maintenance expenses to keep the machinery or factory in working condition). The extra cash can also be used to look for strategic acquisitions since there will be many distressed assets or companies available during the crisis.

2. Change the capital structure

The company has to look at two kinds of leverage. One is the operating leverage and the other is the financial leverage. If a company has EBIT much lower than revenues then it means that the fixed cost of the company is large and it has a high operating leverage. Financial leverage is high if the company has got very high debt to equity ratio. If the company is having high leverage (Operating or financial) then it can be considered speculatively capitalized. This effectively means that the company is taking a leveraged bet assuming the market conditions will improve. However the downside is that if we get our assumptions wrong, the loss will also be magnified. However the payoff is asymmetric. That is the impact of 50% growth in revenues is not the same as 50% drop in revenues.

The ways to tackle the operating/financial leverage are

  • More variable pay: Reduce fixed salary employees (or increase the variable component of the employees)
  • [PH4]  One example is Reliance Industries Ltd, India’s most valuable company raising $15.2bn over the past few months by selling the minority stake in its tech subsidiary Jio to Facebook and Alphabet and thus becoming a zero debt company as they had promised to its shareholders. The company outperformed the Index by around 70% from the lows of March 2020.
  • Interchanging the responsibilities of employees within the group. For example, admin staff can help with the sales team and vice versa. This will make the organization agile and should be able to adapt faster to environment changes.
  • Shift to SAAS and Cloud: This will enable the companies to lower the fixed costs further and improve the data security when employees are working at different locations. Companies can move to cloud/SAAS based ERP systems which will reduce the capital investment expenses.

Why is the capital structure important on a theoretical basis?

Trade-off theory of capital structure states that there is an optimum debt equity ratio above and below which the value of the firm shall be lower. As we keep increasing the debt-equity ratio, the interest rate charged by the bond holders shall increase (present value of the bankruptcy costs). However the problem is that we don’t know the optimum debt equity ratio. Hence it is always safe to have a lower leverage.

The optimum debt equity ratio is unknown

Source: Our estimates, trade-off theory of capital structure by Miller

3. More information (both good and bad) to shareholders not less[PH7] 

If less information is provided, the analysts/investors will assume the worst case or make their own assumptions to arrive at the valuations. By providing more information to the shareholders during a crisis, the investors won’t attach an “unknown factors discount” there by valuing the company fairly with lower fluctuation in the share price.

While it is not the job of the management to inflate the value of the company, it has a responsibility to ensure the company is fairly valued in the interest of shareholders. It would be difficult to provide any sort of guidance. So what are the kinds of information the investor are looking at this time?

  • Sensitivity analysis: What would be the sensitivity of the different factors to the bottom-line? (for example if it’s a financial firm how much impact in the equity and net profit for a +/- 1% change in the interest rates)
  • Liquidity and cash: Provide more details about the immediate cash outflows and inflows anticipated. This will give more clarity of the liquidity position.
  • Worst case scenario: If the company is able to provide information about the worst case scenario and how the company is prepared for it, that would comfort the investors
  • More granularity: It would be a good idea for the company to provide more granularity of its results by segments, geographies etc.

4. Minimize the Covid 19 disruptions

Even under the best case scenarios we are at least 12 to 18 months away from the vaccine and another 12 months more to vaccinate the entire population. Hence we are forced to live with the virus dealing with the cycle of disruptions and restarting of business at different geographies over the next few years. While we all need to follow the expert guidelines on the health and safety protocol to avoid the infection we need to be prepared with a business continuity plan in case any of the staff is infected. The following changes could be adapted to minimize the disruptions.

  • Flexible workforce: The responsibilities could be swapped between the colleagues in between to ensure that there is always a backup for each and every employee. This would ensure the smooth running of the business even under a health crisis for any one employee.
  • SAAS/Cloud: Company data operation can be moved to cloud/SAAS so that the company property is secured even while the employees are working from home.
  • AI: An example would be a chat bot solving the issues of the customer or bots interacting with customers over a telephone line.
  • Supply chain localization: The company’s plan could get disrupted if any of the vendors/suppliers in different geographies are impacted due to Covid 19 (due to health or local regulations). It would be a better idea to reduce the dependence on any single vendor/supplier and that will benefit the company in the long run.

As the pandemic peak in different regions, the human behaviour (washing hands, wearing masks, not touching face, personal hygiene) of the community will respond more and more leading to a slower spread of the pandemic. This is akin to a child (as it grows) learning not to touch the hot vessel. As the humans start learning about the virus and become more and more used to it the infectivity will drop (This is independent of the government actions). Though we all can hope for a better tomorrow, it would be foolish not to be prepared for any eventuality.


Dibin M Koruthu, CFA, is an ex-J.P. Morgan sell side financials sector analyst
Dibin M Koruthu

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