# Concerns for Down-Spherical Valuation of Extremely Leverage Firms

The spread of COVID-19 severely slowed the operating results of many companies in the second and third quarters. In addition to the injuries, some of these companies also service high debt burdens, which further constrains liquidity. When declining operating results meet high debt service obligations, the result is often round-the-clock financing. Of course, there are not only significant concerns from both board members and existing investor groups about the pricing of such a funding round, but also potential biases that understandably may exist between new and old investor groups. The aim of this article is to highlight some key concepts from the theory and practice of financial valuation that, in such circumstances, in the current environment can be helpful in determining fair stock valuations.

## Key concepts in the current environment for the discounted cash flow method

**Beta rescheduling is a key concept in estimating the return on equity required in the near term.**

In terms of an adequate estimate of the cost of equity, modern financial theory and practice suggest that we should focus on beta under the CAPM (Capital Asset Pricing Method) (specifically, estimate an unguided beta first and then estimate it at the the debt to equity ratio (D / E) of the company). The non-leveraged beta only reflects the relative systematic volatility of equity (in a debt-free environment), while the newly leveraged beta reflects the incremental volatility of equity that is appropriately manifested due to the existing debt burden. The other components of CAPM are by no means “given”, but they are probably less prone to material fluctuations in interpretation, application and size than beta.

Trying to estimate a reasonable no-leverage beta for a privately held company usually relies on analyzing a sample set of publicly traded guideline companies (GPCs), where such betas are often easy to observe. The key concept of the renewed leverage of beta is then optimally carried out as an iterative process for expected value projections within the discounted cash flow method, with which the D / E ratio required for the calculation itself can be taken into account directly. In times of crisis like the current climate with the COVID-19 pandemic, it is not uncommon for an iterative beta with new leverage to indicate the cost of equity, which is the same as the ex ante cost of venture capital (VC) investors (i.e. 30% to 50% per year or higher). Given this analogy with VC investments, it should be fairly obvious that such a relatively higher cost of equity reflects a relatively higher likelihood of loss to shareholders.

**The marginal cost of debt is a key concept in estimating the company’s short-term WACC.**

While it seems reasonable to use a company’s actual cost of debt in the traditional WACC formula, the reasonable rate would be the company’s marginal cost of debt, which can be understood as the rate of return required on the next dollar in credit. For companies considering down-round investments, it is not uncommon for the marginal cost of debt to be significantly higher than the cost of existing debt. The marginal cost estimate of debt may come from an observation of recent leverage from a guideline company with comparable business and credit quality, or from a broader analysis of the return of multiple debt instruments from companies with similar ratios / ratings, perhaps another source obtained by the management team. In addition, as the company’s implicit debt-to-capital (D / C) ratio increases, so does the marginal cost of debt, and in practical terms, at very high D / C levels, this marginal cost of debt is understood to add to the non-leveraged cost of equity approach. Alluding to the earlier VC investing analogy, it is not uncommon to see venture capital rates in the 10% to 14% or higher range, which, as noted, approach the unlevered cost of equity of these affected companies. Of course, and as expected, for companies with relatively high D / C ratios, the marginal cost of post-tax debt will, by definition, dominate the WACC calculation in the short term, which leads to increased accuracy of the pre-tax marginal cost of the debt estimate (as well as the post-tax estimate taking into account the Restrictions on interest tax deductibility in light of the TCJA and current CARES Act allowances) is warranted.

**Finite time horizons are a key concept for abnormal (daring) capital costs.**

As mentioned earlier, cost of capital approaching the ex ante rates of VC investors implies a relatively higher probability of loss for investors in the short term, which for discussion purposes could reasonably be estimated at three to five years. However, this cost of capital also provides a substantial likelihood that the company will ultimately be “successful” at the end of the venture investor’s holding period. At this point in time, the cost of capital is expected to “normalize” over the long term. Accordingly, modeling a normalization of the cost of capital as an end condition is justified in such circumstances and may in fact imply exit ratings and exit multiples of the company in question at that future point in time that are consistent with the general expectations of market participants. In contrast to the previous discussion of WACC, a normalized WACC is likely to be dominated by the estimated cost of equity (at a much lower beta with new leverage), with the assumption of a persistent, sustainable debt burden required to reduce the total cost of WACC through the tax deductibility of capital Interest.

## Key concepts in the current environment in terms of market multipliers

**Sales multipliers are a key concept in operational downturns.**

If key operating figures such as EBITDA for a certain company or a certain industry drop significantly, the informative value of the observed EBITDA multiples such as the frequently used company value (BEV) is multiplied.[1]/ EBITDA multiple is often reduced. While the instructivity of BEV / EBITDA multipliers may be reduced in such scenarios, the instructivity of observed BEV / revenue multipliers (BEV / R) is often quite strong due to their frequent correlation with relevant performance data such as EBITDA margins. From a statistical point of view, the confidence gained from such analyzes increases with the number of observations used, and therefore analyzes of market multiples that take into account more observations are usually preferable to those that take less into account.

**Treating operating leases appropriately is a key concept related to “debt,” BEV, and EBITDA.**

Following the introduction of Accounting Standards Codification (ASC) topic 842 – Leases, capitalized operating leases (COLs) are now recognized as liabilities on the balance sheet. Accordingly, and literally overnight, the BEV of many GPCs appeared to “jump” significantly in various financial information databases due to the significant number of COLs now on the balance sheet. For many industries, such as B. retail chains, the number of COLs on the balance sheet can be large, which has led to confusion when calculating the BEV multiples. In particular, we observed a well-known database service that suggested that the correct response to this new accounting method was to formulate BEV multipliers by i) removing COLs from BEV while at the same time removing ii) rental costs from EBITDA (i.e. EBITDAR). Of course, this only added to the original confusion of having COLs in the BEV calculation and, overall, caused a brand new mismatch error. The analytical preference here would be to exclude COLs from BEV (while leaving rental cost in EBITDA), but an alternative treatment of leaving COLs in BEV while using EBITDAR seems to be gaining a following and may be acceptable too.

**The lower relevance of historical M&A multipliers is a key concept in the event of market disruptions.**

In contrast to the market multiples observed above with GPCs, which at least reflect the contemporaneous investor sentiment, M&A multipliers observed in periods prior to the pandemic may be viewed as slightly less relevant given the changed risk sentiment and growth prospects in the current environment started at the end of the first quarter. In other words, the main drivers of multipliers can be reduced to risk (i.e. cost of capital) and growth for illustrative purposes, and either an increase in risk or a decrease in growth expectations (or possibly such changes at the same time) can reasonably be expected to result in relatively lower multiples. Conversely, a decrease in risk or an increase in growth expectations (or possibly both changes at the same time) can reasonably be expected to result in relatively higher multiples. In both cases, the pre-pandemic risk and growth expectations contained in historical M&A multiples may no longer reflect current sentiment, making historical M&A multipliers less relevant.

## Summary

As operating results weaken for companies with high leverage, equity valuations require increased awareness of how best to use and interpret financial valuation tools. Both beta (not leveraged and re-leveraged) and the company’s marginal cost of debt are key concepts for estimating the short-term, ex-ante weighted average cost of capital as part of an iterative process of short-term post-tax marginal costs for debt can be the WACC calculation dominate. However, the relatively high WACC estimates that result from such calculations are only appropriate over a limited time horizon, analogous to the short-term ex-ante holding period expectations of venture capital and debt instruments, with normalized cost of capital being observed over the long term, if in contrast then the normalized cost of equity will likely dominate the WACC calculation. Concurrent BEV / R multipliers observed for GPCs, as well as a thorough understanding of the appropriate treatment of COLs and rental costs (for BEV and EBITDA margin respectively) under the new accounting guidelines should be informative for further confirmation of this downward round of stock valuation estimates in the current environment.

[1] BEV = equity + debt – cash equivalents

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