Rising inflation and interest rates can impact business valuations through their effects on discounted cash flow and the cost of capital. Understanding their impact will be crucial to accurate business valuations in the current environment.
Inflation and Earnings
When valuing a business using the discounted cash flow method, a professional valuator must determine whether the business can grow earnings at the rate of inflation or higher. For example, can the business raise prices high enough to cover its rising material and labor costs? If not, the business will experience negative growth, which will impact value.
The effects of inflation on revenue will vary based on how elastic demand is for its products and services. This, in turn, is affected by factors such as the level of competition in the marketplace and whether substitute products and services are available. It’s also affected by whether customers consider the product or service to be a commodity and discretionary or non-discretionary.
Inflation’s effects on business value will depend on the lifecycle stages of its products and services. For example, high inflation could have the least effect on value during the growth stage and the greatest effect during the maturity and decline stages, perhaps even shortening the length of these stages.
Inflation uncertainty is lower for improvements to existing products or services sold to existing customers. This is due to the impact of yield improvement or waste reduction being amplified in an inflationary environment. Meanwhile, inflation uncertainty is higher for new products and services sold to new customers. The uncertainty caused by inflation also affects the cost of capital.
Maximizing employee retention can pay off during periods of high inflation by reducing the costs of hiring new staff. At the same time, any cost savings realized from temporarily cutting back on staff training and development should be weighed against the potentially negative effects on employee morale and efficiency.
High levels of inflation will also affect financial considerations, including cash management strategies. For example, you might compare the holding cost of cash to using a line of credit, or reducing accounts receivable and extending accounts payable against the potential effects this might have on your relationships with customers and suppliers.
Interest Rates as an Input
Value is driven mainly by cash flow, so valuation experts typically use some sort of buildup method to determine the capitalization rate for valuing a business. Interest rates are one of the inputs to the formula. Therefore, if interest rates rise by two percentage points, what would have been an 18% discount rate becomes a 20% discount rate, thus lowering the value of the business using the discounted cash flow valuation method.
In other words, the higher the interest rate is as an input into the discount rate, the lower a business’ value will be. This and the business’ rate of growth factor into the capitalization rate, which capitalizes a measure of earnings or cash flow into today’s dollars. The higher the capitalization rate, the lower a business’ value will be.
An example helps illustrate the effect of rising interest rates on business valuation. This example assumes the appraiser is using a buildup method to calculate the capitalization rate.
Understand the Impact
No one can predict where inflation and interest rates are headed, so it’s important to understand how they affect valuations now and in the future. Doing so will help you arrive at more accurate business valuations.
Contact us if you have questions about the impact of rising inflation and interest rates on business valuations.
© Copyright 2023 Allinial Global.
Disclaimer of Liability
Our firm provides the information in this article for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this blog are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability and fitness for a particular purpose.