(Estimated reading time: 2 minutes 51 seconds)
The article in brief:
- VRC’s PJ Patel joined a webinar held by the International Institute of Business Valuers (iiBV) on takeaways from the spike in market volatility at the end of 2018.
- Panelists viewed the spike as temporary; while the potential for a recession was weighing on their minds, they were reluctant to predict when or if one might come.
- The volatility did prompt participants to consider appropriate methodologies for factoring market indications into valuations and reflect on when “smoothing” techniques should be employed.
VRC Co-CEO PJ Patel and VRC’s Canadian affiliate partner Peter Ott recently joined other valuation professionals in an online discussion of the end-of-2018 volatility spike moderated by iiBV Board Member Peter Ott and Executive Director Michael Badham.
Panelists noted that the VIX volatility index climbed to 36, roughly double its long-term average, around Christmastime. Though it came down markedly a few weeks into the new year, they said the late December increase posed a challenge as companies and investment funds closing the book on 2018 were forced to reconcile what in many cases were still bullish long-term internal growth forecasts with conflicting messages from the market.
A Temporary Phenomenon
Most discussion participants agreed that the end-of-the-year volatility was temporary and likely not indicative of an incipient recession (though all were mindful that the current economic expansion is getting long in the tooth such that a recession could be around the corner). One panelist suggested the late 2018/early 2019 volatility simply represented the market “searching for a level.”
Nonetheless, Badham asked Patel how, as a practical matter, valuation professionals dealt with it in their year-end processes.
Patel called it the latest illustration of a balancing act that he said has been shaping the valuation industry at least since the Great Recession:
“We’ll obviously use the spot price as part of our (market) valuation. But of course, we’ve also got an income approach and a transaction approach that are longer term. And then we’ll rationalize the current values based on a 30-day average, 60-day average, 90-day average. And quite frankly, for the purposes that we’re doing valuations (financial reporting), even look at prices after the valuation date. Again, this is all with the idea of, sort of, rationalizing our value estimate as of, in this case, 12-31-2018.”
The group also explored the challenges market volatility poses to valuation methodologies that rely on discounting cash flows because the “flight-to-quality” by investors in times of stress tends to drive down the risk-free rates that are used to discount future cash flows even as equity risk premiums are high, thus potentially leading to valuation mistakes.
“You sort of wonder and maybe even have to question if the forecast is the same, but the value is different, is it the discount rate changes over time?” said Patel. “Is there a different perception of risk in the market and therefore the discount rate is what gets adjusted not necessarily the forecast?”
The balancing act between near-term market indications, which may be bearish, and longer-term issuer-level data and forecasts that still appear bullish, leads many valuation practitioners to incorporate “smoothing” into their work. The panel explored when smoothing is appropriate and how is it supportable when the market is signaling one thing, and the company’s fundamentals are telling a different story?
Patel suggested that to some extent, the answer is predicated on the purpose of a valuation:
“When we’re doing, for instance, goodwill impairment testing and valuing pieces of a business and doing a market cap reconciliation, I’d say there’s a lot more smoothing in that sort of situation. We are using longer-term estimates of value. Like an income approach or a transaction approach.”
However, in other parts of VRC’s business—for example, portfolio valuation, where the firm works with funds that invest in private securities to help them strike NAVs—it may be appropriate to attach greater weight to spot market conditions.
Vol Isn’t Value
Market volatility, the panelists agreed, is often driven by factors far removed from the intrinsic value of a business enterprise, and that warrants caution.
“Be careful of short-term volatility,” Patel said. “We see prices change, especially significant changes in stock prices and at the end of the day we need to ask, ‘Is that really indicative of value or something else?’”
We invite you to view the webinar recording on the iiBV’s Vimeo channel.