Company Valuations in Context to COVID-19

From The Desk Of Our CIO… Joe Halpern, Chief Investment Officer


Having issued a COVID-19 Update just last week and with everyone in the world laser-focused on the spread and immediate effect of the disease, we figured it is a good time to discuss how businesses are generally valued and then circle back to how the virus truly affects those valuations.

Let’s start with a simple hypothetical paper company, we will call it Munder Difflin (“MD” – and yes, I finally got to watching “The Office;” don’t tell me the ending…).

If we decided that we wanted to purchase MD we may look at earnings over the last few years and infer a growth trajectory. If MD made $100K this year with a 10% growth rate for the next 5 years and then 5% thereafter and we necessitated a 15% return on equity, the valuation for MD may look like this:

Now let’s say we estimate that between disruptions and weak sales due to COVID-19 that this year’s earning would drop 50%, but that once contained we expect earnings to return to prior levels. In that case the valuation adjusts as follows:

As can be seen, most of the present value is due to the Terminal Value, which is simply all future expected earnings discounted to present value. Furthermore, a 50% drop in earnings this year has only a 4% negative effect on valuation ($988K as compared to $1.032 mil).

Following is the hypothetical base case as well as some other potential outcomes:

  • Base Case: A 50% drop in earnings where weak sales are simply lost rather than recaptured with the event isolated to the first year only.
  • Best Case: MD recaptures some of the losses in year 1, either later in year 1 or year 2. Valuation would drop less than 4% in that scenario.
  • Worst Case: Bankruptcy! MD cannot afford to navigate disruptions due to negative cash, lack of borrowing capability and client concerns (due credit concerns).
  • Recession Case: A longer period of depressed earnings due to disruption resulting in other cracks and weakness within the system.

Bringing it back to the virus, the Street initially believed that the outcome would look like our Best Case though there are increasing concerns that some combination of Worst Case and Recession Case may play out. Ultimately, the outcome is dependent on how the virus plays out and how much financial support is needed and provided to the most vulnerable companies to avert cascading negative scenarios of closing companies, supply chain disruptions and unemployment.

The graph below shows three scenarios that Vanguard put together on the virus’s effect on China GDP. All scenarios assume that business normalizes within the next half a year – which has been the norm in past outbreaks. This means Vanguard most likely assumes that the Virus is beat one way or another or, at the worst, is not beat but allows business to proceed.

Source: Vanguard Investment Strategy Group

Now we fully expect both the US and China to provide a high level of financial support to the economy. Ignoring the uncertainties and justified health fears, there is real risk to smaller companies who cannot afford to weather a three to six month period of true negative cash flows. If enough smaller companies go belly up it will tremor through the economy as well as exposing cracks that were not noticed prior. At the moment though, the graphic on right represents the general expectation of most institutional managers we have spoken to.

IMPORTANT DISCLOSURE: The information contained in this report is informational and intended solely to provide educational content that we find relevant and interesting to clients of Fountainhead. All shared thought represents our opinions and is based on sources we believe to be reliable. Therefore, nothing in this letter should be construed as investment advice; we provide advice on an individualized basis only after understanding your own circumstances and needs.

COVID-19 (Coronavirus) Update

From The Desk Of Our CIO… Joe Halpern, Chief Investment Officer


On Monday, February 24, world markets took a large one day hit due to fears that COVID-19 would become a pandemic. The S&P 500 dropped 3.35%, erasing gains for the year. We are at a moment in time in history where the “news cycle” is measured in seconds and the ability to understand what is verified, researched, and true is becoming more difficult to discern. Evidently similar disruption occurred with the advent of the telephone, among other technologies, leading to some disastrous misunderstandings (e.g., Spanish-American War).

With this in mind, we attempt to answer two items here:

  • Thoughts on risk of the virus as well as trusted sites to stay updated
  • Thoughts on risks of further global sell-offs

COVID-19 – A Pandemic?
The Centers for Disease Control and Prevention (CDC) has a good FAQ detailing COVID-19 which we expect will be kept up to date. We recommend using it as a primary source in understanding the current situation, best practices in prevention, and what to do if you think you may have the virus.

At a high level, the virus seems rather contagious, though with a death rate that we anticipate will continue to drop (currently 2.3% in China, though with a much lower rate within China outside of Hubei Province). Given two characteristics of the virus, one that there is a relatively long incubation period where the carrier is contagious, and two that most of those infected are asymptomatic or experience minor symptoms (81% – note above link), we speculate that the number infected is most likely grossly under-counted. The positive of this is that would mean a lower death rate. The negative of this is that the likelihood of a pandemic, meaning it spreads worldwide, is much higher.

As mentioned in our January commentary, biotech is already working on vaccines and medication to combat the disease. Our expectation is that, outside the worst-case scenario where the virus actually shifts and becomes more dangerous,  the death rate will continue to decline as we better learn the most effective path of treatment.

Financial Impact
We have spoken to a number of institutional managers and the general consensus is that while they expect short-term disruption, the market will rebound. Their primary thesis is that economic activity will eventually come back on-line. Their upside case is that quarantines are effective but even if they are not, eventually the quarantines will go away (downside is that it is a pandemic which results in no reason for mass quarantines). Once economic activity resumes, a majority of lost business is recaptured as well as future expectations which drives the bulk of equity valuation.

Source: Vanguard Investment Strategy Group

In our view, there is a worse downside risk than discussed which is that the virus exposes cracks in the economic system where certain companies cannot weather the disruption. Some of this risk is mitigated by what seems like unlimited capability to throw money at the problem by the governments of China and the US, essentially kicking the issue further down the road (e.g., high government debt levels, artificially low interest rates) – a conversation for another time.

We continue to closely monitor impact of the virus, its effect on the markets, and to analyze potential shifts or opportunities. Please feel free to reach out to discuss further.

IMPORTANT DISCLOSURE
The information contained in this report is informational and intended solely to provide educational content that we find relevant and interesting to clients of Fountainhead. All shared thought represents our opinions and is based on sources we believe to be reliable. Therefore, nothing in this letter should be construed as investment advice; we provide advice on an individualized basis only after understanding your own circumstances and needs.