Cataclysmic events such as deadly pandemics are a major risk to people and businesses everywhere. Business value is all about risk and return. So it should come as no surprise that risky times bring changes to business values.
What do the public capital markets tell us about the effect of the Covid-19 pandemic? Just take a look at the Dow Jones Industrial Average performance year to date. Starting at a lofty 28,868 on January 2, 2020; the Dow dove into the doldrums by mid-March hitting the low of 18,591 by March 23!
Cost of capital shifts
Now take a look at the US Treasury yields over the same time interval. The 10 year bond yields went from around 1.8 in early January 2020 all the way down to 0.75 by late March. What gives?
The investors have been fleeing to the safety of government backed bonds and dumping stocks along the way. Such volatility and panic-driven behavior have not been seen since the Great Depression.
Investors take a deep breath whenever the big government promises to throw a lifeline to keep the economy afloat. Why such confidence? The United States enjoys the privileged position of owning the US dollar, the world’s reserve currency. You can depend upon Uncle Sam to pay his bills.
So how does all this affect the values of millions of private businesses out there?
Impact on business earnings
First, incomes for many main street businesses tanked precipitously. Many were forced to suspend or curtail operations in order to maintain the social distancing rules from local and state governments.
Think about all those restaurants and bars that had to close their doors. Even the professional practices such as dental offices had to throttle their services sharply to comply with the rapidly changing safety requirements.
Industry sectors affected
Airline and hospitality businesses, even large ones are in a world of hurt. Their fortunes hinge on how effectively the pandemic will be contained over the weeks and months ahead. Government lifelines may either fail to materialize in time or be beyond reach for smaller businesses. As the saying goes you may be seen as too small to bail.
Effect on business value – earnings expectation and risk
In quantitative terms, your business value is impacted in two critical ways: the expectation of earnings and business risk the company is likely to face going forward.
Take a look at the Build-Up cost of capital model commonly used in small business valuations. The discount rate enters into the denominator of the income-based business valuation methods such as the discounted cash flow technique. As the uncertainty in the markets continues, the discount rates are likely to increase thus reducing business values.
Earnings appear in the numerator of business valuation calculations. So if the business is facing a substantial earnings decline, its value is likely to go down as well.
Risky industry sectors that are impacted by the social distancing rules are at the greatest risk. This is sobering news as most main street businesses operate in the huge customer facing sectors of personal services, retail, food and drink, and professional services. Customers either cannot patronize these businesses because of current restrictions, or deliberately avoid them as posing a potential risk of infection due to close interpersonal contact.
Short term risks of business closures are compounded the longer the company stays idle. Customers wander off and find alternative ways to address their needs. Loyal employees leave for good looking for ways to make income. Deep pocketed competitors lurk in the shadows waiting for their turn to pounce back once the market opens.
The last man standing does not need to be the best
Downturns have this unsavory effect on industries. Seasoned business people know it as the ‘last man standing’ syndrome – the competitors that once looked promising could disappear leaving the coast clear for those who could ride out the storm. You don’t have to be the best, just the one who could outlast the turmoil.
While no one has a crystal ball, one thing is clear – the small business market will look very different when the dust settles.