COVID-19 and the Equity Risk Premium Used in Business Valuation

COVID-19 persists in affecting nearly everything, including business valuation.  We continue to monitor developments in the economic landscape at large, as well as within the business valuation community.  One thing that we have all witnessed is that COVID-19 has added uncertainty and therefore, more risk to the U.S. and worldwide economies.

A primary business valuation method that is impacted by COVID-19 is the Income Approach, which is based on the principle that the fair market value of an entity may be measured by the present value of its future cash flows.  The present value is calculated through the use of a discount rate.  A discount rate is the way an investor reflects the risks of an investment.  In simple terms, the higher the risk, the higher the rate of return required.

One element of the discount rate that has been directly impacted by COVID-19 is the equity risk premium (“ERP”).  An ERP reflects the additional return that investors demand for investing in equity securities, as a group, relative to risk-free investments.

One measure of an equity risk premium is regularly provided by Duff & Phelps.  Effective March 25, 2020, Duff & Phelps increased its ERP estimate from 5% to 6%, an increase of 20%.  The rise in the Duff & Phelps ERP reflects some of the additional economic and financial risks of COVID-19 to investors.  An increase in risk, and required rate of return to investors through the ERP, with no other changes in expected cash flow, will generally lower the value of a business.

As COVID-19 continues to impact both Wall Street and Main Street, we will continue to assess the situation and the impact on business valuation.  If you would like to discuss opportunities for gift and estate planning during this unprecedented time or have other business valuation questions, please feel free to reach out.

Schneider Downs has significant experience in preparing business valuations for gift and estate tax, financial reporting, buying/selling and a range of other purposes. Please contact Steve Thimons (412-697-5281; [email protected]) or Thomas D. Pratt (412-697-5615; [email protected]) for more information about our business valuation services.