Inflation and interest rates have been relatively simple and stable environmental factors in making business valuations. But in early 2021, the annual inflation rate started rising above 3 percent, where it had been for more than a decade; the high point was over 9 percent in mid-2022 and it has remained stubbornly high. At the same time, the Federal Funds Rate also rose – from almost zero to 4.75 percent in early 2023.
Thus, it’s crucial to understand how these two key indicators affect discounted cash flow and the cost of capital, and their subsequent impact on business valuations.
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 the 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, and 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 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, for example, if interest rates rise by two percentage points, what would have been an 18 percent discount rate becomes a 20 percent discount rate, thus lowering the value of the business using the discounted cash flow valuation method.
In other words, the higher the interest rate 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.
Understanding the Impact
As with most economic indicators, no one can know with certainty the future direction of inflation and interest rates. By better understanding their impact on valuations, it will be easier to use these factors for future business valuations.
If you would benefit from understanding the business valuation process, contact us. We’re eager to help.