August 19, 2020
Our valuation experts have identified key areas that require the focus of U.S. executives, regulatory compliance professionals, and legal counsel in the COVID-19 environment. We will discuss certain valuation principles, approaches, and methodologies that are crucial in establishing value estimates that continue to be reasonable and supportable for compliance purposes.
It is undeniable that estimating value during the ongoing COVID-19 pandemic, and the associated economic disruption has become challenging. The COVID-19 pandemic has had an unprecedented impact on the world economy, transforming consumer spending habits as social distancing policies and expectations drive consumers away from travel destinations, large gatherings, and brick-and-mortar stores. In this unique economic climate, higher unemployment and lower consumer confidence have caused declines in overall consumer spending, with consumers spending more time shopping online while staying at home, thereby accelerating the already increasing trend of e-commerce. In this report, we have reviewed these economic and social trends resulting from the pandemic as they relate to the impact on the consumer discretionary sector of the US economy.
While the pandemic has had a varied impact among the sub-industries in the consumer discretionary sector, the aggregate S&P Consumer Discretionary Index closely followed the total S&P 500 Index following the rapid contraction of the stock market in March. As shown below, this S&P Consumer Discretionary Index is heavily impacted by Amazon.com, and after excluding this company from the sector, the remaining constituents in the index reveal bleaker results. Consumer discretionary products are in general more sensitive to attributes of a recession, and the social trends resulting from the pandemic compounded the negative impact on the sector. Amazon.com has been an exception to this rule, as its business model has been well-suited to the increase in online shoppers. The influence of this single component serves as an important reminder that despite the relative performance of the Consumer Discretionary Index, examining performance at a more granular level is crucial to understanding the drivers of value for different industries and companies.
Source: S&P Global Capital IQ
Impact on Consumer Discretionary Sector
As we observe the COVID-19 pandemic’s economic disruption ripple through the consumer discretionary sector, we have highlighted three ongoing trends that must be considered when analyzing a company within this sector.
Acceleration of E-Commerce
The COVID-19 pandemic has disrupted and transformed consumer behavior as it relates to purchasing consumer products online and away from brick-and-mortar stores. Sector competitors that do not have a viable online platform to generate revenue will continue to suffer losses as consumers stay at home, while several industries are implementing improved online platforms to help protect market share. Industries that have been able to adapt on the fly have taken advantage of the disruption. The automotive industry has been forced to quickly modify their consumer sales model. For example, AutoNation reported a sharp jump in online-only sales in the automobile industry between March and April, after the company pivoted to an online model. While these initiatives have helped mitigate losses caused by the pandemic and maintain market share, the negative economic shock, resulting from the pandemic is expected to cause a decline in sector revenue.
Decline in Consumer Spending
As a result of the pandemic and corresponding closures of brick-and-mortar locations, the unemployment rate in the U.S. was 11.1% as of June 2020. While this figure has continued to improve since mid-March and reflect notable job gains in the retail trade as brick-and-mortar stores begin to reopen, the significant number of unemployed workers is expected to dampen confidence and limit consumer spending, especially for nonessential items. As a result, overall retail industry group revenue is anticipated to decrease 3.7% in 2020. Additionally, complications in logistics because of the pandemic have negatively impacted supply chain and operations in the retail industry group, causing a decline in profit margins. Although these negative symptoms of the pandemic are expected to improve as businesses reopen, recent outbreaks of COVID-19 across the U.S. may slow the reopening process, creating uncertainty in cash flow forecasts.
Differing Effect on Sub-Industries within the Sector
Since the pandemic shocked equity markets starting at the end of February 2020, the impact of the pandemic has had differing effects on the various sub-industries within the consumer discretionary sector. While we note the Consumer Discretionary Index has outperformed the S&P 500 Index since March, it is imperative to examine the performance at a level below the Index to truly understand the impact on sector components. Failing to do so may result in an incomplete and inaccurate assessment of value. As illustrated in the chart below, we have compared three consumer discretionary sub-industries to observe the divergent impact of the pandemic on sub-industries within the same sector. We note the following trends in the stock market based on S&P 500 Index performance:
- The early impact of the pandemic varied widely across sub-industries. While the General Merchandising Store Index declined 18% during the crash, the Department Stores Index declined 70% during that same period.
- The partial reopening of the economy has helped improve the outlook of this sector, but again to widely difference outcomes. For example, home improvement retail reported a positive return for the year of 14% by June 30, while Department Stores continued to report a loss of 59% by the same period.
Consumer Discretionary Goods are More Exposed than Consumer Staples
A review of the credit market, provided by S&P Global Ratings, provides evidence that the negative impact of COVID-19 has impacted the consumer discretionary sector more severely relative to the broader population of consumer goods. When comparing the data groups and the negative rating actions related to each group, we have observed the following: 
- The data groups classified under GICS as consumer discretionary were subject to a larger number of negative rating actions than the data groups classified as consumer staples. For example, most durable and apparel issuers were subject to negative actions while most food and household product issuers maintained stable ratings.
- The food service sub-industry of the consumer discretionary sector has been largely disrupted because of the closure of restaurants, bars, and live entertainment venues. As such, all issuers in this subcategory received negative rating actions. This disruption creates a ripple-effect across other parts of the economy.
- Interestingly, cosmetics issuers, while categorized as consumer staples, were all subject to negative rating actions. These products are more discretionary in nature as compared to other products in related data groups. As fewer people are working outside the home and attending social events, demand for cosmetics has fallen.
Valuation Implications for the Consumer Discretionary Sector
As highlighted by the above commentary and consistent with other significant global events like the “dot com” crash, 9/11 attacks, and 2008 financial crisis, the current pandemic has created additional complexities when estimating value. However, the fundamental principles of business valuation have not changed. At its core, valuation is a forward-looking exercise. The value of any business or asset is derived by the projected future cash flows that it can generate, the timing of those cash flows, and an adjustment reflecting the uncertainty or risk associated with those cash flows.
Although estimating the value of a business or asset has always contained an element of uncertainty, periods of sudden economic downturn and a sharp rise in market volatility increase these uncertainties and risks – especially when the magnitude and duration of the downturn are still unknown. Will recovery resemble a “V”, “U”, “W”, or an “L + ramp-up” shape? How will the recovery play out across the range of consumer discretionary industries and sub-industries? It is during times of heightened uncertainty and potential impact on these areas that we find it useful to revisit certain key valuation foundational principles, notably, the relevant valuation date and valuation approaches and methodologies.
Implications of the Valuation Date
The selection of the valuation date can become significant during times of an extraordinary uncertainty event. According to valuation standards and general practice, facts considered in a valuation should be “known or knowable” as of the valuation date. If the valuation date is prior to the impact of the COVID-19 pandemic becoming “known or knowable,” then the valuation professional should not consider the impact in the valuation. When was the total shutdown from the pandemic actually a known or knowable event?” The consensus in the valuation community appears to be early to mid-March 2020, which is when the U.S. stock market fell dramatically, and the virus was officially declared a national emergency.
Source: S&P CapitalIQ. Timeline events are sourced from (1) Secon, Holly, Woodward, Aylin, and Mosher, Dave, “A Comprehensive Timeline of the New Coronavirus Pandemic, from China’s First COVID-19 Case to the Present,” May 4, 2020 https://www.businessinsider.com/coronavirus-pandemic-timeline-history-major-events-2020-3; (2) Hitchner, James A. and Warner, Karen A., “COVID-19: A Timeline of Significant Events, Including the Pandemic’s Effect on the U.S. Stock Market,” Valuation Products and Services, LLC; (3) Hansen, Sara, “Trump Signs $484 Billion Coronavirus Relief Bill,” April 24, 2020 https://www.forbes.com/sites/sarahhansen/2020/04/24/trump-signs-484-billion-coronavirus-relief-bill/#41964f882228; and (4) “Economic Research: The Federal Reserve Performs A Rebalancing Act To Ease Conditions,” https://www.spglobal.com/ratings/en/research/articles/200618-economic-research-the-federal-reserve-performs-a-rebalancing-act-to-ease-conditions-11536732
Even if the valuation date precedes the known or knowable date and the valuation does not consider the expected financial or operational impact of the COVID-19 pandemic, the valuation report should clearly state this fact to avoid confusion. This position is consistent with the guidance in the AICPA VS Section 100 Subsequent Event Toolkit.
Impact on Valuation Approaches and Methodologies
Market volatility and risk have certainly increased from the pandemic, impacting industries and sub-industries of the consumer discretionary sector to differing degrees. With this backdrop of heightened risk and uncertainty, we will discuss some of the implications on the primary valuation methodologies, key assumptions, and considerations to help ensure that one can maintain compliant valuations during these turbulent times.
The three approaches to business valuation (i.e. market, income, and asset) are all predicated on future earnings streams that can be generated from a business. Under the asset approach, the business value is the price at which its assets could be sold. Under the income approach, the business value is the present value of the future earnings that can be generated from the use of its assets. Under the market approach, the stock prices of publicly traded companies or the price that an acquiror pays for a business are based upon the investor’s expectations of future earnings.
The two primary methods under the Market Approach are the Comparable Transactions (CT) Method and the Guideline Public Company (GPC) Method. Under the CT Method, valuation multiples from historical completed transactions involving comparable companies are applied to the subject company. For the GPC Method, valuation multiples for publicly traded comparable companies are calculated using the public company stock prices. For both methods, comparability of the guideline transactions and companies, as well as confidence in both the numerator (price) and denominator (financial metric) are important in the derivation of valuation multiples. Each of these variables will be uncertain in a COVID-19 environment and certain earnings adjustments will have to be made.
For the CT Method, this challenge of comparability becomes heightened during a sharp economic downturn with wide-ranging and varied local market impact. Even if transactions for comparable companies or assets can be identified, these transactions occurred in the past during different economic conditions and acquiring entities most likely had very different growth expectations as compared to the current market.
For the GPC Method, the valuation multiples are in part based upon the public company stock prices that reflect the economic downturn and resulting investor expectations. However, current stock prices may incorporate short-term expectations and not be representative of the long-term prospects for the comparable companies. Selection of comparable companies may also require more diligence as, noted previously, companies in the same broad sector (e.g. department stores and home improvement retail stores within the consumer discretionary sector) may be impacted very differently by the pandemic.
Additionally, the valuation professional should place more emphasis on the projected revenues and earnings of the public companies and consider calculating valuation multiples based upon those forward-looking metrics rather than last twelve-month metrics. These projected revenues and earnings are based on the company’s expectations considering the pandemic.
The Discounted Cash Flow (DCF) Method and the Capitalized Cash Flow (CCF) Method are the primary valuation methods under the Income Approach. Under the CCF Method, normalized earnings are capitalized into the future assuming an estimated discount rate and a constant level of growth. For the DCF Method, the projected cash flows are discounted back to a present value utilizing an estimated discount rate. Mathematically, the CCF and DCF Methods are similar, except that the CCF Method assumes a constant rate of growth whereas the DCF Method allows for variable growth rates over a discrete period of time.
Because the CCF Method determines a value based upon a single period of earnings, the calculation of normalized earnings is critical. In these uncertain and volatile times, the extent of adjustments and normalization necessary to arrive at a single earning period considering the uncertainty related to future expected cash flow, timing of those cash flows, and risk factors reflect weaknesses in this methodology that may render the approach impractical.
The DCF Method is the preferred valuation method given that it is best equipped to incorporate the specific business’ expected cash flow, timing of those cash flows, and risk factors. The advantages of the DCF method becomes even more pronounced given the current and future expected uncertainty and volatility that companies face today. Earnings are projected for each discrete period in the short-term, allowing flexibility to factor in risk through the derivation of the discount rate, sensitivity analyses, and probability-weighted scenarios.
For most consumer discretionary valuations, the Asset Approach is passed over, as the Income and Market Approaches more appropriately capture the value of a going concern business. However, as stated earlier, there will be more financial stress on already distressed retailers, and some businesses may need to be valued under a different premise of value that focuses on the liquidation value of the underlying assets versus a going concern presumption. Therefore, in this environment there may be an increased number of valuation opinions where an Asset Approach indication of value is relied upon for the conclusion of value. This approach is generally atypical in the valuation of retailers and would represent a notable shift. When considering an application of the Asset Approach, some evolving issues to monitor are:
- How is the working capital of the businesses impacted by the shutdown?
- Does the business have the necessary reserves to fund the restart of operations?
- Can the business re-hire any furloughed employees?
- What is the impact on any owned facilities and/or real estate?
- Have any debt covenants been triggered and if so, can the company obtain forbearance agreements?
- Is there potential economic obsolescence related to any assets?
Given the COVID-19 pandemic environment, additional analysis is important for valuations in the consumer discretionary sector. In summary, key valuation implications and challenges include, among others:
- Examining performance at a more granular level within the consumer discretionary sector to understand the drivers of value;
- Focusing on multiples of projected revenue and earnings using the GPC method on a set of carefully selected public companies;
- Adjusting multiples paid by companies for targets acquired pre-pandemic, potentially making the CT method a more challenging valuation method;
- Using the DCF income method versus the CCF income method to enable capture of the uncertainties in cash flow projections during the projection period of the DCF; and,
- Considering the use of an asset approach valuation method for distressed businesses.
The prevailing environment will require an enhanced focus by executives, regulatory compliance professionals, and legal counsel on reasonable and supportable valuation approaches, methodologies, and assumptions that reflect the specific facts and circumstances of each business or asset.
 The Global Industry Classification Standard (GICS) defines eleven economic sectors, including the Consumer Discretionary sector, along with several industry groups within each sector and its underlying industries and sub-industries. This report focuses on the Consumer Discretionary sector and refers to industry groups, industries, and sub-industries within the Consumer Discretionary sector as appropriate.
 Per S&P Global Capital IQ, the S&P 500 index declined to its lowest point for the year on March 23, 2020 after reaching historic highs in late February 2020.
 The data shown on the chart below as related to the S&P 500 and S&P 500 Consumer Discretionary sector includes actual index returns per S&P Global Capital IQ. The data related to the Consumer Discretionary sector, excluding Amazon, was manually calculated by tracking the change in float-adjusted market capitalization of all constituents of the S&P Consumer Discretionary index, excluding Amazon.
 “Coronavirus – What Americans are Buying Online While in Quarantine,” Rattner, N., CNBC, April 19, 2020.
 “Opportunities & Challenges: Online Car Sales,” IBISWorld, June 25, 2020.
 U.S. Bureau of Labor Statistics.
 “Industry Report 44-45: Retail Trade in the US,” June 2020. This revenue forecast includes all retail companies, including food and staples retailing. We would expect discretionary retail revenue forecasts to be lower than the overall retail forecast.
 “U.S. Consumer Product Ratings Demonstrate Pandemic’s Double Edge–Consumer Staples Benefit While Discretionaries Struggle,” S&P Global Ratings, June 12, 2020. We have compared the data groups provided by S&P Global Ratings to GICS and have identified the data groups as subcategories of either the Consumer Discretionary or Consumer Staples sectors.
 “In situations in which a valuation is meaningful to the intended user beyond the valuation date, the events may be of such nature and significance as to warrant disclosure (at the option of the valuation analyst) in a separate section of the report in order to keep users informed (see paragraphs 52p, 71r, and 74). Such disclosure should clearly indicate that information regarding the events is provided for informational purposes only and does not affect the determination of value as of the specified valuation date.” (https://www.aicpa.org/interestareas/forensicandvaluation/resources/standards/aicpa-vs-section-100-subsequent-event-toolkit-coronavirus.html)