The recent COVID-19 pandemic and resulting economic disruption/recession have created significant uncertainty, to say the least, regarding future expectations for many entities. This has resulted in significant volatility in the value of assets and securities as witnessed in the public stock markets. Part of this volatility results from differing expectations regarding recovery from the pandemic and recession. But does this change how we value companies? Let’s review….. There are three approaches to value: cost, market, and income. Within each approach, various methodologies can be used to determine the value of an asset, security, or entity. Some methodologies may utilize historical performance metrics, i.e. last year’s revenue or an average of net income for the past three years, as a base to determine value. This is frequently done if past performance can be used as a reasonable proxy for future expectations. Other methodologies may use expected performance metrics or an explicit projection of future financial performance to determine value.
Traditional Discounted Cash Flow
When an asset or entity exhibits stability in benefits and risk, the DCF may reconcile with or parallel valuation methodologies that rely strictly on past performance metrics. However, when changes in benefits or risk characteristics are expected, the DCF may yield value indications that differ from other methodologies that do not reflect those changes.
DCF with Economic Uncertainty
Back to current events and significant economic uncertainly. Part of the beauty of the DCF is the ability to incorporate expected discrete changes in benefits and/or risks in the value of the asset or entity. The DCF can be used to model changes in expectations resulting from the pandemic and quantify changes in value. Referring back to our simple example and reflecting changes in expectations resulting from, say, recent events: if net benefits were expected to drop 25% in the first year but recover completely by the fifth year, the value could change as follows:
If expectations different from those above were probable reflecting uncertainties in the marketplace, scenarios of expectations could be developed with each one used to indicate value under different conditions. These different indications of value could be used to develop a range of value or weighted based on an estimate of their probability of occurrence to indicate a single estimate of value.
As you can see, the DCF is a versatile methodology when determining the value of an asset or entity that relies on expectations of future benefits. It can quickly be adapted to incorporate changes in expectations and used with multiple scenarios of expectations.