How Does the Market Affect the Value of Your Privately Held Business?
By Sadikshya Karki, Supervisor, Advisory Services
When we think about what a closely held business may be worth, we often focus on the company’s history of successes and failures, sales, earnings, list of customers, and its location. However, we can’t value private businesses in a vacuum. Along with the risks and expected returns specific to the company, various market factors influence a company’s value.
When the financial market is mentioned, a lot of buzzy headlines come to mind, such as “NASDAQ jumps, stocks recover,” “The Fed raises interest rates,” “Improvement in inflation,” or “Fear of recession.” But how do these market conditions affect the valuation of a privately held business?
How Does the Stock Market Affect Value?
IRS Ruling 59-60, which governs valuations of businesses, specifies that appraisers should examine “the market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.” Similar companies within an industry are assumed to benefit (or suffer) similarly under market conditions, whether public or privately owned.
However, an exact apple-to-apples comparison is not always possible for a number of reasons:
- Owners of stocks of public companies can freely trade their stocks at any given moment based on a readily available share price. On the other hand, owners of a private company are subject to restrictions on liquidity and marketability. In addition, often times, those owners may need a business appraisal done to assess the fair market value of their ownership interest as of a certain valuation date.
- Private companies typically have longer holding periods.
- Closely held businesses may have unique or specialized characteristics that make it difficult to identify truly comparable public companies.
Private company multiples, like valuation multiples in the public markets, can be influenced by market hype to some extent. When significant market hype surrounds a particular industry or sector, investors are either highly optimistic or subject to FOMO (fear of missing out). Limited public information on private companies also makes it easier for market hype and speculation to influence multiples. This may result in investors willing to pay higher multiples for companies operating in that space, ultimately leading to inflated valuations driven by sentiments rather than a careful assessment of the company’s risks and expected returns. For example, during periods of hype around emerging technologies, private companies operating in these areas have commanded higher multiples. However, it is essential to note that market hype usually only temporarily influences private company multiples. Over the long run, valuations tend to revert to a company’s actual financial performance and realistic growth prospects.
How Do Rising Interest Rates Affect Value?
IRS Revenue Ruling 59-60 also guides appraisers to consider “a company’s earning capacity and dividend-paying capacity.” Interest rates can profoundly influence a company’s cost of capital, which is the return expected by those who provide capital for the business.
When the company’s earning streams are used as a basis for valuation under the income approach, value is derived by discounting future cash flows or capitalizing historical earnings by the company’s cost of capital. The higher the cost, the lower the value of the company’s earnings. Rising interest rates increase the magnitude of the following individual components that make up the cost of capital:
- The Risk-Free Rate: The risk-free rate is the foundation of the cost of capital. It is a theoretical rate of return that an investor would anticipate from a zero-risk investment over a given period. The risk-free rate increases with rising interest rates because appraisers often use the expected returns on long-term U.S. government bonds as a proxy for developing the risk-free rate.
- Risk Premium: An investment in a private company can be riskier than an investment in a risk-free asset such as Treasury bills. Risk premium is the component of the cost of capital that accounts for the return investors demand for taking on the additional risks involved with an investment in a private company. When interest rate on safer investments such as bonds rise, the opportunity cost of investing in privately held businesses increase. In such a situation, investors command a higher risk premium, which ultimately reduces the value of a company.
- Cost of Debt: Interest rates affect companies’ borrowing capacity. Companies that operate with debt in their capital structure face a higher cost of borrowing with rising interest rates. Although a company may realize marginal gains as interest payments are usually at least partially tax-deductible, payments on debt are required regardless of business revenue. This may further affect a company negatively during an economic downturn. Also, depending on a company’s business operations, high interest rates can depress market demand and, thus, earnings. For example, in the construction industry, high interest rates have softened the market for some new construction projects, dampening the earnings of construction firms and contracting, materials suppliers, and other related industry participants.
Is Inflation Always a Negative?
Inflation and interest rates are related since interest rates are used as a monetary tool to avoid rapid growth inflation. Generally, rising inflation impacts the value of a private business by hurting its earnings. This is especially true for companies that operate in industries that compete on price, such as retail, restaurants, grocery stores, and airlines. The impact of inflation may not be as severe for companies that (a) operate in industries such as information technology or financial services that are less impacted by commodity prices or (b) companies in industries such as pharmaceuticals and healthcare, subscription-based services that can pass rising costs on to consumers.
Inflation also impacts the risk appetite of an investor. Inflationary pressure added to the existing risks associated with investing in a private business will ultimately lead to investors demanding a higher return, leading to an increased cost of capital, resulting in lower value for the company’s earnings. This is also true for companies operating in industries that are typically exposed to economic cycles, such as construction and manufacturing.
What About the Fear of Recession?
Is the U.S. economy headed for a recession? This has been a hot topic lately. Declining consumer spending due to a fear of recession can lead to reduced earnings for businesses, and in this climate, obtaining financing for the purchase or expansion of a privately held business can also become more challenging. Potential buyers and investors may become risk-averse during economic uncertainty, leading them to seek safer investments. Lenders in such a scenario command higher interest rates and more stringent terms, which can make transactions less appealing to all stakeholders.
Furthermore, fear of an economic downturn can lead to delays in business transactions. Buyers may postpone acquisitions, and sellers may hold off on selling their businesses in the hope of better economic conditions, limiting liquidity in the market. However, it may also be possible that during a recession, some companies, especially the ones operating in an industry sensitive to a downturn, are forced to be sold due to economic challenges, resulting in strategic buyers acquiring such companies at a discount.
Overall, it is essential to note that movements in the market do not impact the value of all businesses in the same way. Valuation of privately held business always require the careful analysis of factors such as the nature of a business’s industry as well as the industries in which its suppliers and customers operate.
Movements in the market present opportunities for owners of privately held businesses depending on the company’s position and the owner’s goal. While it is typical for business owners to want to sell their business when the economic optimism is high and liquidity is abundant in the market, an economic downturn may also present some opportunities. If you are considering gift and estate planning, an economic downturn may be the right time. Lower values resulting from an uncertain economic environment can be advantageous for tax minimization strategies.