Estimated reading time: 3 minutes
Last month, we delivered our observations through a valuation expert’s lens and measure how events have impacted equity market indices, adjustments to EBITDA expectations, and their influence on enterprise values by sector through the first half of 2020. The receptive response to this information was overwhelmingly positive and, as such, we provide here an update to the data through August 31, 2020, to provide updated information for assessing potential impairment issues as the end of the third-quarter approaches.
It bears repeating, most sectors show a more substantial decrease in the next 12-months (NTM) EBITDA than a decline in enterprise values. We believe this indicates an increase in market multiples, which can be challenging to reconcile in the current environment. A more reasonable conclusion for many companies is to view 2020 as an anomaly, with businesses expected to return to normal levels in 2021. As a result, the impact on enterprise values has not been as significant as near‐term expected EBITDA. However, given the uncertainty of the pandemic’s future economic effects paired with the timing of vaccine development, 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 current period (August 31, 2020) relative to the 2019 calendar year. In the context of the income approach, we anticipate near‐term expected cash flows to be materially lower, and there may be significant risk associated with expected earnings beyond 2020. There are many different sub‐sectors within the 11 sectors we cover here that may have varying results relative to their overall industry.
The SEC continues its focus on impairments related to COVID‐19. In the first half of 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 continue to show companies requiring interim impairment testing, and the effects on accounting and valuation issues may further evolve before coming to a final resolution.
General Market Event Observations
The COVID‐19 pandemic has created significant volatility in the U.S. equity markets. In mid‐February 2020, all three major U.S. stock indices—Dow Jones Industrial Average, NASDAQ Composite Index, and the S&P 500—reached all‐time highs. However, in late February 2020, stocks began to plunge into correction due to novel Coronavirus fears. Stocks continued to decline as the World Health Organization declared the virus 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.
The turnaround in the U.S. equity markets began on March 23, 2020, when the Fed announced economic support measures. On March 27, 2020, the U.S. signed into law the Coronavirus Aid, Relief, and Economic Security Act (CARES). On April 3, 2020, the Small Business Administration opened its Paycheck Protection Program, which provided loans designed to give small businesses a direct incentive to keep their workers on the payroll. On April 9, 2020, the New York Fed opened registration for the Commercial Paper Funding Facility. On April 24, 2020, the PPP and Health Care Enhancement Act was signed into law, which increased funding to the PPP and provided more funding for hospitals and testing for COVID‐19. These government stimulus programs spurred a material rebound in the U.S. equity markets.
Our first chart illustrates the significant decline from CY 2019 to Q2 2020 for two of the three major stock indices of the U.S. equity markets, as well as the material rebound from Q2 2020 to month-end August 2020 for all three major stock indices of the U.S. equity markets. Through the first half of 2020, the Dow Jones Industrial Average and the S&P 500 were down ~9.6% and ~4.0%, respectively, while the NASDAQ Composite Index was up 12.1%. However, since Q2 2020 to month-end August 2020, all three major stock indices of the U.S. equity markets increased materially, with the Dow Jones Industrial Average, the NASDAQ Composite Index, the S&P 500 up 10.1%, 17.1%, and 12.9%, respectively. On a year-to-date basis, the Dow Jones Industrial Average is down 0.4%, while the NASDAQ Composite Index and S&P 500 are up 31.2% and 8.3%, respectively.
We reviewed the decrease in NTM EBITDA forecasts from the CY 2019 to Current (August 31, 2020) to observe how EBITDA expectations have been adjusted to reflect COVID-related impacts. As expected, the sectors with the most significant decreases to the expected NTM EBITDA are the energy and consumer discretionary sectors. The reduction in the expected NTM EBITDA from CY 2019 to current for the energy sector is materially higher than decreases observed for the change in enterprise values from this same period.
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‐19 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. This, along with the impact on oil price from the Russia‐Saudi Arabia oil price war, are the significant change factors in NTM EBITDA for the energy sector.
Consumer behavior has changed in response to the pandemic, which has materially impacted the industrials and consumer discretionary sector. Due to high levels of unemployment and its impact on incomes, consumers are spending 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 day‐to‐day activities outside their homes without medical endorsement or the development of a vaccine.
As many consumers are still reluctant to return to day-to-day activities outside their homes, it is no surprise that the information technology, consumer staples, and utilities sectors show higher NTM EBITDA currently relative to at CY 2019.
Most sectors experienced a decrease in Enterprise Values from CY 2019 to current (August 31, 2020) compared to the increases observed for the NASDAQ Composite Index and S&P 500 over the same period. The decrease in Enterprise Values from CY 2019 to current for the energy sector was materially greater than observed for the other sectors, given the significant decline in the price of oil due to reduced demand and the Russia-Saudi Arabia oil price war in March 2020. The health care and information technology sectors were the only sectors to experience an increase in Enterprise Values from CY 2019 to current.
VRC can help you address impairment issues accurately and help mitigate inevitable balance sheet scrutiny from auditors, the SEC, and the PCAOB. We welcome you to contact the article author, Jason Mutarelli, or any VRC professional for other expert views on market and valuation considerations surrounding potential interim impairment testing requirements and other questions you may have.
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[Published Aug. 6, 2020] Observations and measures of how H1 2020 COVID-related events have impacted equity market indices, adjustments to EBITDA expectations, and their influence on enterprise values by sector.
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