What 2020 reminded us about fundamental valuation principles
Students of business valuation theory learn about key principles of notional valuations. The year 2020 – which may very well end up being the most bizarre year of our lifetimes – put these principles on full display. The year isn’t over yet, so publishing this now may prove to be a bit premature, but here are some of the highlights.
Value is determined at a specific point in time and is a function of facts known (or knowable) and forecasts made at that point in time
In 2017, Airbnb reportedly consulted with investment banks about an IPO in the first quarter of 2018 that would have valued the company between $45 billion and $50 billion. However, the company’s CEO resisted the idea of going public at that time. In September 2019, Airbnb finally announced it would go public in 2020 … which may have proved to be the worst possible time to do so. While the company may have rebounded from a valuation of $18 billion earlier this year as it looked to secure a loan at an interest rate of 10%, Airbnb’s valuation was most recently expected to be around $30 billion – a steep discount to what was expected just under three years ago. (Oops.)
A firm’s value is the greater of its going concern value or liquidation value
When Quibi embarked on a strategic review after its notorious failed launch in the early days of COVID, it hoped it could continue operating – either through a sale to an interested buyer, a new financing round, or going public via a reverse merger. But one month later, the company’s board decided that the best option was to shutter. Quibi’s board concluded that winding down and liquidating the company’s assets would return more cash to its shareholders than would struggling to continue operations.
Notional valuations are not frequently done on the assumption that a company will wind down its operations and liquidate its assets. However, 2020 was a reminder that in some cases, this is in fact the most prudent path for a company to maximize shareholder value.
Markets dictate an appropriate rate of return
As stock markets tanked during March and April, the (lower) price that investors were willing to pay for stocks reflected a higher required return on their investment to compensate for a higher perceived level of risk of investing during a period of uncertainty.
Price is different than fair market value
The notional fair market value of a business and the “price” at which it may trade are two distinct concepts. 2020 has reminded us of a couple of key reasons why this is the case:
Reason #1: Fair market value is expressed in terms of cash or cash equivalents. Remember when Xerox tried to take over HP? If not, it’s because it feels like a lifetime ago as a result of COVID. In November 2019, Xerox offered HP shareholders $17 + 0.137 Xerox shares in a hostile bid, which was rejected by HP.
In February 2020, Xerox upped its bid to $18.40 + 0.149 Xerox shares for each HP share. (Xerox closed at $37.69 on February 10, which implied a cash equivalent of $24.00 per HP share.)
However, only a month later, this $24.00 per HP share was no longer equal to $24.00. On March 18, Xerox shares closed at $15.98; accordingly, the cash equivalent became $20.78 (or a ~13.4% discount to the face value of the offer one month earlier).
Reason #2: Fair market value assumes that parties to a transaction are under no compulsion to act. Neither party in the proposed Xerox-HP transaction was under any compulsion to proceed with the deal. One of the reasons that the transaction fell apart reflects the likelihood that the terms of the proposed deal were no longer in line with what both parties perceived to be the fair market value of HP.
Some investors, however, presumably were compelled to act during the stock market downturn and unloaded stocks at a ‘fire sale’ price because of a need for cash. Analysts, investors, and academics can argue over the efficiency of public markets, but during the periods of volatility in which the ‘circuit breaker’ was triggered on the New York Stock Exchange during early 2020, it is arguable that trading prices of certain stocks deviated from their fair market values – if only temporarily.
In a theoretical valuation, the use of hindsight is generally not permitted
Had Airbnb known that COVID would hit, the company likely would have made changes to its business model and revised the timing of its IPO. Had investors in Quibi known that its user base would end up being only a fraction of what the company forecast for its first year, they likely would have invested their cash elsewhere. (A chequing account with 0% interest would have been a better choice, in retrospect.)
And had an investor known that the Dow Jones Industrial Average would surpass 30,000 by the end of November when the index hit its low point of just over 18,000 earlier in 2020, they might have sold every asset they owned and purchased US equities. But neither Airbnb, nor Quibi, nor the average investor is clairvoyant – and the average investor would need the benefit of hindsight to know where the Dow would end up by the end of November.
Hindsight may be 20/20 but, generally speaking, it can’t be used when attempting to establish a theoretical or notional valuation of a business at a historical point in time. This, of course, makes a notional valuation in the year of COVID even more difficult than it usually is.
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