There is a magazine about everything including family law and today I watched a short video published at the end of May by Family lawyer magazine. The guest interviewee was Jay Fishman of Financial Research, a business valuation company based just outside of Philadelphia. Fishman is among the doyens of this profession, so when I saw an interview about current trends in business valuations, I thought 15 minutes would be well spent. The interview is here:
As Jay points out at the beginning, business valuation is a process by which we take current data about a business and try to predict its future value. Now, almost all of us have lived through a financial cycle where predicting the future seemed almost impossible, but the leading examples are the long-induced stock crash of 2008 and the sudden pandemic collapse of 2020. While the Federal Reserve’s swift action and Congress on both occasions bailed out the economy in both 2008-9 and 2020-21, with the latter recovery fueling inflation that has led to a very volatile stock market so far in 2022. In the 1970s we experienced stagnation and inflation. Today, inflation is certainly there, but the job market is one that can’t really be explained. The Federal Reserve is trying to reduce inflation by raising interest rates, but this has caused many startups launched in the boom economy from 2011 to 2020 to either collapse or run for cover by cutting jobs. Other companies with deep pockets jumped in. Amazon has long considered getting into the healthcare business. This week, they forked over almost $4 billion in cash to acquire One Medical, a primary care network. The price is twice what the market thought the shares were worth the day before Amazon announced the acquisition. The healthcare industry has been watching Amazon for some time to see where the giant will dip its toe in the water.
If there was a central point in the interview with Fishman, it can be summed up as: the best valuations are made when appraisers know the industry and trends in which the company competes. Almost anyone can “calculate” and arrive at a business value. But Jay noted that to prevail in a valuation case, the expert must not only understand the economic environment in which the target business operates, but also be able to explain this to the person or persons tasked with deciding which valuation to prevail .
In these cases, the rubber hits the road when it comes time to evaluate the capitalization or discount rate. There are several elements in this four-part test that have been quite volatile so far this year, not the least of which is the risk-free rate of return, typically derived from the 20-year Treasury yield. A year ago, that number was around 1.8%. Today it is 3.27%. So if you’re sitting on a six-month valuation, your risk-free analysis will be “off” and need to be updated, producing less business value. Then you add to that the capital risk premium, which involves comparing equity returns to government debt returns. A year ago, the S&P 500 was at 4,500; today just over 4,000. Most investors today find the stock overvalued even after its 11% decline this year. Then there is the size premium. Smaller companies typically have less cash and less borrowing flexibility. A buyer of a small company wants a higher return because of the risk that the company will not survive a bad economy. Some big fish have washed up on the beach since 2020, demonstrating that size doesn’t always insulate larger companies from financial trouble. Revlon filed for Chapter 11 in June. Penneys, Neiman Marcus and Brooks Brothers preceded it. Some of these appear to be victims of a pandemic, but there is no doubt that retail as we know it remains in a state of flux; and these listed companies were supposed to be the deep pockets.
A related topic is specific industrial risk. Three years ago, a share of Carnival Cruise Lines would have cost you $60 or more. Covid effectively shut down the business, with the stock hitting $12. Last summer, when we thought vaccines were defeating Covid, the stock climbed back to almost $30, but the variants of Covid, unrest around the cruise ship world and rising fuel costs took the stock below $9; 25% lower than the stock traded when the boats were banned from sailing. Meanwhile, Marriott is trading higher than it was before the pandemic and Hilton has taken off as airline stocks struggle with service reliability and fuel prices. The pandemic drove General Motors to $20, but by January 2020 it had tripled from that low. Alas, the Fed’s rate hikes and Putin’s influence on gas prices have nearly cut GM in half over the past six months. Tesla, meanwhile, has rallied from $96 to nearly $830 over the same period, even as lithium crude prices have risen faster than oil prices.
The market is not always rational, but it is always in motion, and if you are working on a business valuation, you and your expert must follow the bouncing ball. If you don’t, the grade in your file risks becoming out of date and looking out of date or maybe even silly.