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March 13, 2023

Valuing companies in a recession

Bad times may be good, or they may just be bad!

Market Valuation
Brock Benson

By Brock Benson

There have been a few hiccups over the last 20+ years but, generally, we've been in a long-term bull market. How do we utilize data from this period in light of the recent slow-down and pending recession?

In times of economic downturns, valuing companies becomes more challenging yet increasingly crucial for investors and analysts. Recessions bring about heightened uncertainty and volatility, making traditional valuation methods less reliable. In this article, we explore the strategies and considerations involved in valuing companies during a recession.

Understanding the Impact of Recessions on Valuation

During recessions, several factors come into play that can significantly impact a company's valuation:

  1. Declining Revenue and Profitability: Economic contractions often lead to reduced consumer spending, lower corporate earnings, and shrinking profit margins for companies across various sectors.

  2. Increased Risk and Uncertainty: Recessions amplify business risks, including credit risk, market risk, and operational risk. Uncertainty about future cash flows and market conditions can make valuations more challenging.

  3. Tightened Financial Conditions: Access to capital becomes limited as credit markets tighten, affecting companies' ability to fund operations, invest in growth, or refinance debt.

Valuation Strategies in a Recession

1. Cash Flow-Based Valuation:

During recessions, cash flow-based valuation methods, such as discounted cash flow (DCF) analysis, are particularly relevant. Analysts forecast future cash flows, adjusting for the recession's impact on revenue growth, profit margins, and capital expenditures. Discounting these cash flows back to present value at an appropriate discount rate reflects the increased risk environment.

2. Relative Valuation:

Comparative valuation methods, such as price-to-earnings (P/E) ratio or enterprise value-to-EBITDA (EV/EBITDA) ratio, can also be useful in recessionary environments. However, adjustments must be made to account for the recession's impact on earnings and multiples of comparable companies.

3. Asset-Based Valuation:

In downturns, asset-based valuation approaches gain prominence, especially for companies with strong tangible assets. Adjusting book values of assets to reflect current market conditions and considering potential impairments due to economic distress is crucial.

4. Scenario Analysis:

Given the heightened uncertainty during recessions, scenario analysis becomes essential. Analysts evaluate multiple scenarios, including base case, best case, and worst case, to assess the range of potential outcomes and their respective implications on the company's valuation.

Key Considerations

When valuing companies in a recession, several key considerations should be taken into account:

  • Quality of Management: Assessing the company's leadership and their ability to navigate through challenging economic conditions is crucial.

  • Industry Dynamics: Different industries may be affected differently during recessions. Understanding sector-specific challenges and opportunities is vital for accurate valuation.

  • Debt and Liquidity Position: Companies with excessive debt levels or inadequate liquidity may face heightened financial distress during recessions, impacting their valuation.

  • Government Interventions: Government stimulus measures and regulatory changes can have significant implications for company valuations. Staying informed about policy developments is essential.

Conclusion

Valuing companies in a recession requires a blend of art and science. While traditional valuation methods provide a foundation, they must be adapted to account for the unique challenges posed by economic downturns. By employing cash flow-based analysis, relative valuation techniques, and scenario analysis, investors and analysts can gain insights into a company's intrinsic value amidst turbulent economic conditions. Additionally, staying abreast of industry trends, management quality, and government interventions is essential for making informed investment decisions during recessions.