THE UNCERTAINTY GENERATED BY COVID-19 IN TRANSACTIONS: BACK TO BASICS
The Coronavirus is having serious impact on the health of hundreds of thousands of people worldwide,
We find ourselves before a new situation that is affecting us in all areas: from the organisation of work to family and personal relationships and, of course, with a very significant impact on different economic sectors.
Equity markets have reacted in an expected manner, with significant falls in their quotes that on average are situated at 30% but that amount to over 50% in those sectors that, short-term, are most vulnerable to the new situation: tourism, airlines, oil, etc.
Without doubt, the quick adjustment in the value of said assets follows the uncertainty generated in this new situation that causes many investors to prefer to close their long positions and not to be present in a market where information isn’t flowing in a completely transparent way or it simply isn’t available. The size of adjustment, this 30% on average, follows the laws of supply and demand and the moment comes when certain investors consider that it is the right valuation to again adopt a buy position.
In the area of transactions (M&A, Private Equity), we are without doubt faced with a scenario where the difficulty in defining the value of business, in a context of high uncertainty, can cause price formation to be governed by other criteria (the need to buy or sell, strategic aspects, gaining market share, etc.) or that simply that decisions concerning investment are delayed or cancelled.
But in these moments of uncertainty, it is necessary more than ever to stop, go back to the start and ask yourself what the variables are that create the value of an asset or of a business and that, summarised, amount to three: generation of cash flow, growth and risk
1) Generation of cash flow:
As in any financial crisis the impact is going to be different according to the business sector we are talking about, but also to each company’s own characteristics: the level of previous indebtedness, geographical diversification, client or supplier dependency, size, cost flexibility etc.
However, in the current situation, other variables exist outside the company structure itself that may determine significantly the start of crisis recovery, mainly companies’ access to new financing (equity and/or debt) and the effective deployment of policies implemented due to the crisis by central banks and governments (tax, labour, etc.).
But in my opinion, the fundamental variable that determines the ability to generate cash flow and, therefore, for companies to create value, is going to be time. How long can companies and businesses endure the current situation? And, more importantly, what condition will they be in once all this is over?
Variable growth, in valuation, refers to the expected growth of generated cash flow, to which we referred in the previous section. The higher the expected growth, therefore, the higher value expected.
Data has recently been published regarding the fall in retail consumption in China due to the Coronavirus crisis, that plummeted by 20% in February, when the last few years showed an annual growth of over 8%, following 20 years of continued growth. This is without doubt alarming data that one way or another will become apparent in Europe and other regions.
Just as worrying is the standstill in investment in China that has, without doubt, caused the growth. The saver, the investor that has resources, the companies themselves prefer to wait until there is a greater visibility concerning the future and reserve their funds or they allocate them to assets that have no related risk. What we saw in financial markets is transferred to the real economy, to individuals and to companies.
Lastly we have the variable risk, understood as uncertainty, volatility or variability expected in the cash flow generated. In valuation, we reflect this concept via the rate of discount or of the valuation multiple. The higher the risk, the lower the value or multiple.
In the current situation, industries such as those related to tourism, travel and oil, tend to easily be placed in the same basket of high risk sectors, at least occasionally, and other recent ones such as online sales, remote telecommunication systems, online courses, or as classic as supermarkets or general food as industries with a low risk profile.
By definition, investors are adverse to the risk that they cannot control, to uncertainty and especially to the current insecurity that exists. The way to protect themselves is through price discounts, reducing the valuations.
These three variables are those that have always determined and will determine in the future the valuations of the assets and of the business and, obviously, they are going to behave in a very different way in the coming months or years according to the business sector in question.
La equation of the coronavirus from an economic point of view has these three conundrums: X, Y, Z and, the success of the corporate recovery of our country and the strengthening of company structure will depend on the ability of the government, the company managers and the investors to dispel them.
For this, however, it will be necessary to resolve a priori the most important variable, that of slowing down the virus pandemic, which is a necessary condition, but is not enough to return to the path of growth and again reach prosperity within our civil society.
But we must not forget that where there is a crisis there is an opportunity, and the companies that are better prepared, the most solvent, can take advantage of opportunities of acquisition, will be capable of financing their investments well and come out of this situation stronger.
Cesar García is director of the Financial Advisory Services area in Mazars
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