Valuation Updates in a Post-Pandemic Economy

Six major themes your appraiser will be focused on in this year’s update cycle.

With mandates and restrictions easing across the country, most of us are cautiously optimistic that we are finally moving on from the effects of Covid-19. While parts of life begin to resemble normalcy, many economic consequences of this unprecedented environment continue to be felt at both the macro and micro levels. As a result, certain factors are likely to garner high levels of attention from valuation advisors. Whether you’re an employee-owner, a key decision-maker, an ESOP trustee, or an ESOP advisor, you can expect to see increased emphasis on the following six major themes during this update cycle:

Supply chain constraints
Labor force challenges
Sustainability of demand
Inflation impacts
Rising interest rates
Balance sheet swings

While it can be measured in a number of ways, estimating value is fundamentally an exercise in quantifying the future benefits to be realized through ownership, while assessing the risk of realizing those benefits. Valuation is therefore an inherently forward-looking exercise, as evident by the persistent scrutiny directed by advisors towards the forecast assumptions presented by management teams. While CEOs and CFOs are often quick to remind their valuation advisors that no one can predict the future, we rely heavily on information and sentiment drawn from company leadership to help assess these predictions and formulate the numerous judgments that go into estimating value.

To this end, if you are involved in the valuation process for an ESOP company, either as an executive, a trustee, or a board member, it is more important than ever to consider how these six factors impact the future outlook of the business in question, and more specifically, how these factors have been addressed in any forecast being developed by management. Your valuation advisor, if not overtly seeking your input on these issues, will surely be considering them in the valuation process.

We expand on this topic in our podcast episode.

1. Supply Chain Constraints

There’s no shortage of discussion around supply chain challenges during the last year, from the chip shortage to delays in container deliveries to name just two. While these are two obvious examples and in many ways related to the labor shortage we’ll discuss momentarily, there are several less obvious impacts posed by supply chain uncertainty that may warrant consideration in your assessment of the future outlook. Your valuation advisor may ask you questions like:

Are there any raw materials or other production inputs that are or may soon become difficult or more costly to source? If so, how are you mitigating the risk of disruptions? (i.e. substitutes, vendor redundancy, stockpiling, etc.)
In the event you are unable to procure the materials necessary to perform your contracted services or ship your finished goods, how will your revenues be impacted? Are these sales merely delayed or permanently lost to a competitor with the ability to meet demand? How can this impact your customer relationships moving forward?
Compared to other years, how reliable a measure is your backlog as support for the revenues you expect to generate this year given the potential for supply chain issues to hamper your ability to service / produce the work / goods?
Conversely, if you’re in a position to benefit from supply chain chaos (i.e. transportation / logistics providers, domestic alternatives to imported goods, etc.) how sustainable is this current level of performance? How can your performance be impacted should currently reduced competitive pressures resurface?

2. Labor Force Challenges

Regardless of the character of your workforce, the pandemic has increased the cost and difficulty of recruiting and retaining personnel for employers across a broad spectrum of industries. Pandemic-related issues, coupled with a significant reduction in overall workforce participation resulting from a variety of factors, caused staffing challenges not seen before in recent memory. While an extremely complex and fluid topic to address, you may hear questions such as:

Have your recent results been impacted by labor shortages, and if so, in what ways? Do you expect these issues to persist, and if so, how have they been factored into your forecast?
What steps, if any, have you taken to mitigate the risk of losing a consequential portion of your workforce? How have you communicated with the workforce surrounding the issues / dynamics facing your company?
Aside from direct compensation, what drives people to work for your company? How has the pandemic strengthened or weakened these non-monetary incentives?
How dependent is your company’s success on the retention of certain key individuals? What contingencies are in place to address the sudden and unexpected departure of one or more of these people?
If you’re projecting growth in the near future, does your forecast reflect the substantially higher cost (in many instances) of adding additional personnel? Is it still reasonable to use recent averages or other metrics to inform forward-looking cost assumptions? Cost issues aside, can you find and attract the necessary people?

3. Sustainability of Demand

After the exhaustive rhetoric around “pent-up demand” and “v-shaped recovery” espoused in 2020, one could argue that these sentiments were at least partially validated in 2021 as businesses in certain industries generated record levels of performance thanks to robust consumer and commercial demand. If 2021 was marked by material shifts in demand within your segment, you can anticipate questions like:

How sustainable are the current levels of demand ultimately proven to be? Has your company experienced similar instances of short-term demand spikes in the past? If so, what were the catalysts for the return to more normal levels?
What measures have you undertaken in an effort to meet this level of demand and how easily may they be reversed or unwound in the event that demand subsides? More specifically, how variable are the new costs you’ve layered on this year vs. what fixed or long-term commitments have you made? (i.e. wage increases, new / expanded lease footprints, multi-year contracts, etc.)
How has the pandemic impacted the barriers to entry in your industry? Given the elevated levels of demand, what new competitive pressures are on the horizon? Has remote work enabled competitors in new geographies to compete in your markets, and if so, are you equipped to compete in theirs?
Conversely, if the pandemic has significantly reduced demand in your segment (i.e. movie theaters, shopping mall retail, etc.) what evidence / support exists that demand will recover in the near future, if at all? How are you responding to changes in consumer behavior that are likely to persist?

4. Inflation Impacts

While the macro effects of inflation can have a significant influence on specific company valuation (to be explored in theme #5), the most impactful result of inflation is generally the impact inflation has on a company’s major costs and ability (or inability) to pass these costs on to customers. Many industries experienced profit margins bolstered by the inflationary pressures, as customer tolerance for price increases has enabled revenue growth in excess of rising input costs, but others have seen costs rise precipitously, while revenues have stagnated or even declined. Regardless of which category your business falls in, your valuation advisor is likely to raise questions like:

What percentage of your revenue growth was attributable to price increases vs. higher output? If you raised prices this year, when did the changes take effect, and in what magnitude? Do you expect additional increases in 2022?
Conversely, if your revenues were flat or declined in 2021, did inflationary price increases offset the underperformance, and if so, to what extent? Holding output constant, what would revenues have been at 2019 – 2020 rates / prices?
How directly are you able to adapt your pricing to changes in your cost structure? Are you exposed to fluctuations in your input costs on future projects / orders for which you’ve already committed to pricing? What hedges, if any, are available to bracket these costs?
What visibility do you have towards your primary costs in the near future? Can you lock in prices for a certain length of time, or are you subject to changes with little or no advance notice?

5. Rising Interest Rates

Aside from a company’s core P&L, the other major impact that inflation is likely to have on valuations in this year, but perhaps more so in the 2022 – 2023 update cycles is through its impact on interest rates, capital markets, and M&A activity / multiples. As inflation increases, pressure will continue to mount on the Federal Reserve to increase benchmark interest rates. The vast majority of valuations derive their cost of capital using U.S. treasury rates as a starting point. Thus, all other things held constant, rising interest rates will place upward pressure on discount rates yielding lower indications of value under methods based on future cash flows. At the same time, as rates of return on corporate bonds and other fixed-income instruments return to more attractive levels, the capital that was reluctantly invested into equities in search of yield may be increasingly reallocated back towards a more risk-averse allocation within their portfolio (translation: they’ll sell stocks to buy bonds). These large capital outflows could place significant downward pressure on valuations in both the public and private equity markets, which may have little or no correlation to degrading fundamentals or concerns around future company performance.

Unlike the other factors we’ve discussed so far, your valuation advisor is unlikely to spend much time asking you about the impact of rising interest rates on your business unless the drivers of demand in your industry are fundamentally exposed to these factors (i.e. financial institutions, mortgage lenders, residential builders, etc.) or your business carries high levels of variable interest debt within its capital structure. That said, we urge you to open a dialogue with your advisor around the impact of these macroeconomic factors on your valuation as any large changes in value attributable to broader market trends beyond the company’s control may pose a challenge in employee communication to the extent that the change in value is not fully correlated to company performance.

6. Balance Sheet Swings

Whether the result of a highly profitable 2021, the forgiveness of one or more PPP loans, appreciation of company-owned real estate, or a combination of these and any number of other factors, many businesses saw their balance sheets strengthen materially over the course of the year. While some portion of this additional value may need to be retained and re-deployed in service of the company’s near-term growth objectives, the prevalence of robust cash balances, deliberate inventory build-up, or aggressive debt repayment may place upward pressure on share prices this year whether or not the value of the operating business itself (aka. the “enterprise value”) has seen a similar increase. Absent clear and deliberate communication with employees, this creates confusion around the reasons for the higher share prices particularly if performance was below expectations. In assessing what aspects of your balance sheet may warrant special consideration in their analyses, appraisers may pose questions like:

Does the CFO, controller, or treasury team manage the business with an ideal amount of cash in mind? Is there an amount of cash that would represent the minimum level required by the company to operate comfortably?
What uses of excess cash, if any (i.e. debt repayment, strategic investments, one-time bonuses / benefits, etc.), may the board or management team explore in the near future?
If you’ve built up inventory reserves in anticipation of further supply chain hurdles, are you able to quantify what portion may be considered “excess”? In the event that demand softens before the reserves are worked down, what other avenues are available to liquidate the excess inventory?
What impact may the asset-driven increases in per-share value have on the company’s ability to meet near-term repurchase obligations? Have these demands on current and future cash flows been considered in the company’s forecasting / capital budgeting?

Conclusion

While value is primarily driven by company performance (and more importantly, the expectation of performance in the future), outside factors influence company performance every day. What’s more, outside factors like interest rates, consumer sentiment, capital market conditions, and other various aspects impacting the subjective perception of risk, which may or may not directly impact company performance, still impact value.

While the future is always unknown, what we do know is that we are living in an era of greater uncertainty than ever before. A tight labor market showing no signs of easing, supply chain challenges that may take years to fully resolve, and other economic and political uncertainty add to the increasing perception of risk. All of this, coupled with a trend of higher inflation, rising interest rates, and more volatility in capital markets, means that this year’s valuations will be as challenging as ever. Preparation, thoughtful discussions with your leadership team, and engagement with your advisors will all lead to a better overall result as you move through this year’s administration cycle.