Three tips for A/E business valuation in the time of COVID-19

COVID-19 is causing constant changes for A/E and environmental firms and it can be a challenge to know what lies ahead. Morrissey Goodale offers three tips for firm owners valuing firms in 2020

By Morrissey Goodale April 17, 2020

Over the last few weeks, the coronavirus pandemic sent principals and firm owners in the A/E and environmental consulting industry scrambling to ensure the safety of staff and clients while shifting to a remote working paradigm. Today, executives have transitioned from internal crisis management to shepherding firms and staff through a highly uncertain environment. In addition to the short-term uncertainty around clients and projects, there lurks the larger unknown of the impact of the COVID-19 crisis on each design firm’s long-term revenue, profits, and therefore valuation.

We have already seen the effects of the pandemic in the public markets, with investors suffering an extreme degree of volatility that erased, and then partially regained, a vast amount of wealth. After hitting its closing high on February 19, 2020, the S&P 500 fell 34% through March 23. It then regained nearly half those losses through April 14. As compared to one year prior, the benchmark index was down only 2%. Similarly, the Nasdaq Composite Index also hit its closing high on February 19, followed by a 30% decline through March 20. After a rebound rally of similar magnitude to the S&P 500, the Nasdaq was actually up 8% as compared to the prior year.

The good news right now, if there is any, is most owners and principals in the A/E industry work in privately held firms, and therefore didn’t have to watch personal investments in their firms fall and rise with the public markets in the first quarter of 2020. However, as the financial repercussions of the coronavirus ripple through the economy and state and local governments weigh whether and how to get people back to work, firm valuations will likely suffer. While that plays out, we recommend the following for firm owners valuing firms in 2020:

1. Evaluate the demands of ownership transition on cash flow. This speaks directly to firms in the middle of an ownership – and potentially a leadership – transition.  Many plans we see involve one or both of a) retiring partners selling shares back to the firm and b) rising partners – possibly with the help of internal or external financing – buying into ownership. Either action may impact a firm’s cash on hand in a way that affects operations. Cash is king, especially in a crisis or a contracting economy, and we recommend firm leaders carefully consider how an existing or planned ownership transition may need to change or even pause for the good of the firm (and its cash).

2. Check your financial projections. Then check them again. All formal valuations for firms in this industry rely heavily on forecasts of future earnings, both in the current year and years to come. Unfortunately, business in the time of COVID-19 calls into question financial projections made last week. We recommend staying on top of all projections regarding revenue and billings. Be realistic as a management team about which projects may nor may not continue and which invoices are likely or unlikely to be collected. Make updates to forecasts in real time.

3. Carefully assess the risks in a unique time. For firms updating valuations this year, the calculation may be affected by unusually sharp changes in the discount rate used by the valuation. In normal times, the discount rate is used as a standard approach in valuation to quantify the relative risk of an investment in a specific firm. However, with the Federal Reserve taking extraordinary measures to prop up the U.S. economy in 2020, our fundamental measure of the “risk-free” rate of return, the U.S. 10-year T-note, has been slashed. At the same time, the current uncertainty has led to a spike in risk premiums for firms virtually across the board. A lower discount rate driven by the central bank’s actions, all else equal, will raise the indicated value of a firm, while the higher risk premiums will reduce it. Even for the rare firm that has seen no impact on its business, these economic developments will change what your firm is worth. If your firm is in the midst of a valuation update, we recommend spending the necessary time and effort to make the best estimate of the appropriate discount rate in the calculation, incorporating all known risks at the time.

On a positive note, remember that even the extreme volatility seen in the financial markets at the end of the first quarter of 2020 will pass and longer-term fundamentals will re-assert themselves. As an example, see the share prices of the following industry mega-firms as of April 15, 2020, which takes into account recent volatility.

Table 1: Changes in A/E Firm Share Prices Over One Year

So what to do now while we’re waiting to see whether market volatility is the start of an extended downturn or more of short, though severe, blip in economic history? First, remember that valuation is very much dependent on cash flow. This means bottom-line profits, not just top-line revenue. The lower the profits, the lower a firm’s value, all else equal. Take the steps necessary to preserve revenue, but to preserve share price, focus on preserving profits during the crisis. Second, when in doubt, lean on the advice of experts beyond your firm.

At heart, valuation of an A/E or environmental consulting firm asks a simple question: what’s this firm worth? But in actual fact, the methodology of a valuation, which relies on forecasts and assumptions as much as mathematical calculations, may confound all but the most experienced professional. Especially in uncertain times, the advice of a dispassionate third party may prove invaluable.

This article originally appeared on Morrissey Goodale’s website. Morrissey Goodale is a CFE Media content partner.