How Economic Factors Impact Business Valuations
It seems like every day, there is a new article about inflation reaching 40-year highs and the resulting impacts on everyday life. Whether it is surging vehicle or real estate prices, increasing labor costs, or eggs for $6-$7 a dozen, the effects of the COVID-19 pandemic continue to influence our lives. Because many of these effects appear to be less transitory than economists initially predicted, business valuation professionals must consider how these conditions impact valuations.
For much of 2020 and 2021, many business valuators excluded 2020 operating results in their analysis of ongoing earnings. The presumption was that the complete shutdown of some businesses, and the cascading effects across all industries, caused what would be considered a “non-recurring” impact on cash flow. Some businesses, however, greatly benefited from certain aspects of the pandemic. For example, companies that had readily available inventories of cleaning supplies or personal protective equipment experienced significant increases in revenue and profits. Similar to the companies that experienced declines due to the pandemic, these elevated levels of revenue and profit were not expected to continue.
Now that we are nearly three years into the pandemic, it is time to acknowledge that many companies are operating in a new reality defined by reduced earnings and higher interest rates. How do these two major factors combine to decrease business valuations, specifically in the types of closely held companies that are often at the center of matrimonial cases?
Reduction in Earnings/Cash Flow
In 2021 and 2022, inflation was at its highest level since the early to mid-eighties. This elevated inflation can be traced directly to the lingering effects of pandemic-imposed closures, supply chain disruptions, overwhelmed ports, workforce shortages, and constrained energy sources. While there are disagreements about the relationship between these factors and whether federal policies played a role, there is no doubt about the ultimate result: higher prices for just about every product or service. These increases are not limited to the end consumer product; they have also affected the cost of doing business. It is the compounding effect of the increasing cost of base materials and services that has driven this extreme change in consumer prices.
Though businesses attempt to pass these elevated costs along to consumers, there is always a limit to what customers will accept. In many instances businesses have endured reduced margins and profits. With labor specifically, wages have outpaced revenue growth due to market salary adjustments, new hire signing bonuses, higher starting salaries, increased minimum wages, and the overall scarcity of workers. For companies with flat or minimally increasing revenues, these higher costs directly reduce the earnings available to business owners. On the most basic level, a reduction in earnings equates to a reduction in the value of a company.
Rising/Changing Interest Rates
In an effort to combat runaway inflation, the Federal Reserve has embarked on an aggressive policy of raising the benchmark federal funds rate. Eight times since March of 2022, when the federal funds rate ranged from 0.25% to 0.50%, the Fed has raised the target rate in increments of 25 to 75 basis points. The current federal funds rate stands at 4.50% to 4.75% as of February 1, 2023 which is 4.25% higher than it was less than a year prior. As the federal funds rate increases, so do other interest rates charged or paid by banks. While this can be good news for individuals with saving accounts, it also means higher rates on credit cards and home mortgages. For small business owners, rising interest rates make financing operating expenses and asset purchases through debt more expensive, negatively impacting cash flow. In addition to decreasing earnings/cash flow, rising interest rates impact the capitalization and discount rates used in valuations.
When businesses are valued using an income-based approach (capitalized earnings or discounted cash flows), the value is based on the present value of future earnings/cash flow. The present value of these earnings/cash flow is determined using either a capitalization rate or a discount rate, depending on the appropriate valuation methodology. These rates are often determined via the same methodologies and procedures — a capitalization rate is essentially a discount rate adjusted for expected growth.
One of the most common methods for determining a discount/capitalization rate is the “Ibbotson Build-Up Method”. In this method, a valuator “builds” a discount rate by adding several premiums in excess of the “risk-free” rate of return. The result is the rate of return an investor requires due to the inherent risks with an investment in the subject company. The “risk-free” rate of return is often considered equivalent to the market yield on U.S. Treasury Securities at 20-year constant maturity; the 20-Year Treasury yield. A valuator may use the 20-Year Treasury yield (as of the date of valuation) as the first component in the build-up of their discount rate. Additional premiums are then added to reflect:
- Additional risks inherent in the stock market (equity risk premium);
- Risks associated with investing in a smaller, closely held business (size premium); and
- Risks specific to the subject company (management depth, access to capital, etc.).
These premiums increase the discount rate; the “riskier” the investment, the higher the rate of return an investor will demand. There is an inverse relationship between the expected rate of return and the value of the company — a higher capitalization rate will produce a lower value.
As of December 31, 2021, the 20-year Treasury yield was 1.97%. As the Fed raised rates through 2022, the 20-year Treasury yield increased to a high of 4.59% in October of 2022. As of January 31, 2023, it was 3.78%. As a result, depending on the date utilized, a valuator could be using a capitalization rate that is between 1.81% and 2.62% higher than they would have used at the end of 2021.
Here’s an example of the effect this can have on the value of a company. Assuming $100,000 in cash flow, a business would be valued at $666,667 using a 15% capitalization rate. Increasing the capitalization rate by 1.81% to 16.81% would result in a value of $594,884, while an increase of 2.62% to 17.62% would result in a value of $567,537; a decrease of 11% to 15% in value based solely on the increase in interest rates.
|Capitalization Rate||15.00 %||16.81%||17.62%|
Overall, it is important to remember that income-based valuations are based on the future expected earnings/cash flow of the operating entity. Even though we as valuators often rely on historical earnings to determine future earnings, it is important to factor market and operational changes into our analysis. The ongoing impacts of the COVID-19 pandemic, along with the corresponding government response, have created significant changes in operations and markets for many companies. Given that these impacts persist today, it is important to closely examine changes in operating results over the last two years and adjust accordingly.