COVID-19: Known or Knowable?

This is the second blog in Davis Martindale’s Valuations and “Covid-19 Mini Series”.

The first headlines appeared during January 2020: the outbreak of a novel coronavirus is cause for concern in China, with talk of stopping travel from the reported epicentre in Wuhan. Did anyone foresee what would happen on a global scale in the months to follow?

Today, the “unknown” is a consistent theme whenever Covid-19 is discussed. Although the future economic impact, and the “return-to-normal” timeline are hot topics for speculation, there is no certainty on what the future will look like in Canada or around the world.

This blog will unpack what it means for business valuators to consider whether Covid-19 impacts were “known or knowable” at a valuation date.

Hindsight Knowledge

One of the basic principles of valuing a business is that value is specific to a point in time. It is important that valuators avoid the use of hindsight knowledge in preparing business valuations. Check out our Hindsight: Part 1 and Part 2 blogs for a refresher on this topic. Instead, determining “fair market value” requires “reasonable knowledge of the relevant facts” at the point in time in which value is being determined (the “valuation date”). For example, if a business is being valued as at December 31, 2018, then the fair market value must be a function of the known or knowable facts, and market expectations on December 31, 2018.

An Example in the Restaurant Industry

Let’s use the example of a successful restaurant in Ontario being valued as at January 31, 2020. By the time the valuation is actually being prepared, the valuator will know that government restrictions required this restaurant to close its doors for several months after the January 31, 2020 valuation date. The valuator is in a challenging position: the restaurant had healthy performance leading up to January 31, 2020, so a notional value would reflect that success. However, after January 31, 2020 the restaurant closed its doors and may never open again.

The restaurant owner suggests that they knew by January 31, 2020 that Covid-19 would spell ruin for the business, as they saw headlines that Covid-19 was gathering steam in China and therefore, the valuation should reflect knowledge that the restaurant would be forced to close its doors.

How does the valuator proceed? Is the restaurant valued as a business that has seen healthy growth and success, or alternatively as a business that needs to shut its doors? This brings us to our first point: what is known or knowable at the valuation date?

Known or Knowable?

Back to our restaurant example: the client may have known about Covid-19 on January 31, 2020, but did they know that it would become an economy-halting pandemic? Was this knowable by January 31, 2020? Knowledge of the disease is different than knowledge of a local economic downturn.

It is important that valuators assess, and can support what expectations were known or knowable in relation to Covid-19 at the valuation date in order to determine what knowledge was available to market participants. In our example, is it reasonable to say that news of a virus in China was an indication that a restaurant in Canada would be forced to close in March, 2020? Is this a reasonable expectation?

Industry and Regional Disparities

Our restaurant example is just one industry in one geographic location, but different regions and industries reacted to Covid-19 at different times, and in different ways. Wuhan began a lockdown on January 23, 2020. Almost two months later, the World Health Organization declared Covid-19 to be a global pandemic. The following week, on March 17, 2020, the Ontario provincial government declared a state of emergency, ordering many businesses to close. It seems reasonable that each region might have a different timeline of economic expectations arising from Covid-19.

Likewise, individual industries may have different timelines. The owners in our local restaurant example might expect different business impacts than a business that relies heavily on imports from or exports to China. In this case, it may be reasonable to have earlier expectations that the business will be impacted.

Use of Hindsight to Test Assumptions

When can a valuator indicate that the value of a business is impaired because of Covid-19? Valuators look at operational, economic, and industry conditions leading up to the valuation date, and then use that information to make assumptions about what the future holds for a business. Valuators are then permitted to use hindsight knowledge to assess the reasonableness of those assumptions. It is important that valuation reports explicitly state, and support assumptions made as they relate to the impacts of Covid-19.

If you are uncertain about the value of your business during the Covid-19 pandemic, do not hesitate to give the experts at Davis Martindale a call, we are ready to help.

If you would like a further discussion on any of the topics covered in our mini series, please do not hesitate to call our team.