COVID-19 shakes up the world of company valuation – negative base rate according to IDW methodology for the first time

Stock markets, M&A transactions and other valuation events have already been affected by COVID-19 induced distortions. As a result of the dropping sales markets and the uncertainty of the future economic trend, particular difficulties arise in estimating future earnings and cash flows. These difficulties are already known from many crises.

New with the COVID-19 crises is the effect on the cost of capital. In addition to forecasting cash flows, company valuations also include estimating the required future returns (cost of capital). These result from a risk-free interest rate (base rate) and risk premiums. As a consequence of the distortions on the financial markets caused by the support measures of the central banks, negative base rates (-0.10 %) now occur for the company valuation.

The base rate is calculated in the practice of business valuation according to a uniform methodology – published by the Institut der Wirtschaftsprüfer IDW (Institute of Public Auditors) – for an imaginary, infinite investment. According to this methodology, an investor must permanently assume that he will have to pay penalty interest of -0.10 % for a riskfree investment of the money. This situation is unique in the history of company valuation. Even though investors have long been used to short and medium-term investments only yielding negative interest payments, the idea that infinite financial investments also generate negative interest payments is new to all corporate buyers and sellers or to shareholders who are forcibly compensated in a squeeze-out procedure.

Company valuers are therefore currently intensively discussing the question of how to deal with these negative interest rates: Do the models for deriving the required returns from periods of positive riskfree interest rates have to be adjusted because they are no longer up to date? Or will we simply have to get used to significantly lower yields and rising company values in the future, even if earnings expectations decrease? The currently still high level of the stock markets despite the impending recession makes this second scenario seem not entirely farfetched.

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