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.