Financial forecasting is complex at the best of times, but recent levels of economic volatility make it even more challenging than usual.
Looking back at historical performance figures – usually such an important element of the forecasting that underpins most valuations – isn’t much help given the extent of recent business interruption. Meanwhile, benchmarking pricing metrics has become more complex as the myriad of operating and financial challenges that companies have faced over the last several quarters have impacted different sectors – and different businesses within those sectors – in very different ways.
The unwinding of COVID support measures combined with inflation-related uncertainty creates further complexity that needs to be incorporated into any forecasting.
Jim Davies, FRP Corporate Finance Partner and valuations specialist, points out that the fact that we are now in an extended recovery phase of the economic cycle, amid a backdrop of rising inflation and pressure on interest rates, makes valuing companies, assets and investments far more challenging than in a stable market.
He said: “Valuation multiples vary widely at the moment as companies follow very different recovery paths.
“And there’s an absence of recent transactions in certain industries, so a lot of care and attention is needed in price benchmarking. It’s really important to understand the advantages and drawbacks of different valuation approaches, and to adapt techniques and methodologies to become more suited to the current climate.
“When the pandemic hit, many companies initially focussed on conserving capital for example, so real care needs to be taken to understand their near-term cash requirements to catch-up, adapt and reposition for growth. This goes for operating costs as well as investment in working capital, capital investment, R&D and so on.”
With interest rates still low in a climate of economic, industry and company specific risks, traditional ways of assessing cost of capital must be treated with caution too.
Hanut Dey, Valuations Director at Eight Advisory, adds that transaction multiples are at an all-time high and the cost of capital is at an all-time low. “This hints at the high amounts of capital available to be spent as levels of dry powder continue to grow,” he says.
“I think this is driving the divergence between value and price that will continue to create both challenges and opportunities for valuation professionals in 2022.”
The high-profile floats of electric vehicle makers Lucid Motors in July 2021 and Rivian in November 2021 raise some fundamental questions about value and pricing.
Jim comments: “It would be fascinating to know what assumptions investors made around Rivian’s long-term share of the global auto market. It’s a business with virtually no revenue or production capacity and only a few orders, yet the IPO briefly valued it at over £100 billion – above Honda, Ford, and General Motors.
“These established companies may be less advanced in certain technological areas, but they have spent decades mastering mass production, delivering huge volumes of numerous models to all parts of the automotive market. We have to remember that automotive is incredibly competitive and that almost all players are moving towards electric.”
“There will be a few successful new players, but when we are fully electric it will remain a fiercely competitive market.”
So, how can a company with no discernible earnings and brand-new operations be worth more than mature companies with revenues in the billions?
If we suspect that the implied market share is too ambitious, and the challenges to reaching super-efficient mass volume, mass model production are perhaps understated, then it raises a fundamentally important question around valuation.
To what extent was the IPO valuation supported by investors’ genuine belief in the underlying fundamentals and to what extent by their assumption that the share price would rise further simply due to a swelling of market sentiment?
To put it another way, how far had price diverged from value?
“It’s very often a dynamic around big tech-driven IPOs,” Jim says, “and similar questions have long been asked about Tesla, which was recently valued at over 1 trillion dollars.”
Hanut agrees. He adds: “One argument is that, with the cost of capital currently so low, the present value of longer-term future earnings have more of an impact on the current value, so investors may be willing to overlook near-term losses if they expect the company will ultimately dominate the electric vehicle market.
“At the same time, it seems that one of the factors driving Rivian’s listing value was a single order for 100,000 delivery vans by Amazon, which is also a shareholder.
“However, none of this comes without risk, including the challenges around scaling up production to super-efficient mass volumes.
“It’s likely that investment decisions are probably being made based more on a target price rather than with fundamental valuation principles in mind, which again points to the divergence between price and value.
The challenges mentioned above hint at the potential risks involved in automation of the valuation process.
This is a fascinating area of development that currently attracts a range of views.
Jim added: “In a very stable market, it’s tempting to think that automating valuations is doable, but as soon as stability falls away, the idea seems farfetched. So, while there’s certainly a place for technology in the valuation sphere and Artificial Intelligence (AI) and Machine Learning should be part of that, we need to be pretty careful about how far that goes.”
Hanut goes a step further when discussing the potential of technology in the valuation process.
He said: “With the current pace of development and the new capabilities that AI and Machine Learning present, I think there is an argument to try and integrate these new tools in our overall delivery.
“The end benefit to our teams, industry and clients are clear to see. Consultants are usually not the first adopters of any new technology. However, it just needs a professional brave enough to jump first and then the rest can learn from their initial mistakes!”
But Jim offers the alternative view that valuation is a fundamentally human process that cannot be replicated by technology.
He said: “Value depends on what the market is willing to pay. In the absence of genuine market testing, a valuer’s role is essentially to mimic the process that investors would go through when pricing a target in order to provide an estimate of market value.
“If human beings are driving investment decisions, then it follows that human beings should be driving valuation decisions too.”
He concludes that, while the onward march of technology is inevitable and provides valuers with a wealth of actionable data, valuation professionals should not be worried about being replaced by robots.
Rather, they should welcome the potential for technology to take more time-consuming aspects of the process off their hands.
He said: “While the technical side can and should be supported by technology to drive consistency and efficiency, the commercial reasoning requires a blend of experience, discussion, commercial awareness, challenge and articulation that only human intervention can provide.
“Recreating that process through AI or machine learning is incredibly complex, but I do see there being a continued creep of technological input over time.”
Hanut agrees that human instincts and intelligence will continue to lead decision making, with a growing role for technology in informing those decisions, freeing up valuers to work on more complex and elements.
He said: “Overall, valuations are quite subjective and personal. It would be very difficult for people to be completely replaced by the current level of technology, though we can predict a gradual creep of technological input over time.”
First published in Corporate Financier in April 2022.