The Influence of Economic Forces on Business Valuations

Manage HR Magazine | Monday, April 03, 2023

The impact of a 40-year high inflation rate on everyday life is headline news daily.

FREMONT, CA: Every day, a new article is published about inflation reaching 40-year highs and its effects on daily life. The COVID-19 epidemic continues to impact our lives, as seen by rising vehicle and real estate prices, rising labor expenses, and egg prices between $6 and $7 per dozen. Because many of these effects appear to be more permanent than economists initially projected, practitioners in business valuation must analyze how these situations affect valuations.

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Many business evaluators removed 2020 operating results from their analysis of ongoing profitability for most of 2020 and 2021. The assumption was that the complete shutdown of some enterprises and the ripple effects across all industries had a "one-time" impact on cash flow. Yet, many components of the pandemic were highly profitable for a few firms. For instance, enterprises with readily available cleaning supplies or personal protective equipment stocks saw considerable sales and profit improvements. Similar to the companies that saw decreases due to the pandemic, it was not anticipated that these elevated revenue and profit levels would last.

Now that the pandemic has been ongoing for over three years, it is necessary to realize that many companies are working in a new reality characterized by decreased earnings and increased interest rates. How do these two key variables interact to reduce business valuations, particularly for closely held enterprises frequently at the core of divorce disputes?

CHANGING/RISING INTEREST RATES

The Federal Reserve has aggressively boosted the federal funds rate to battle out-of-control inflation. The Fed has raised the target rate eight times since March 2022, when the federal funds rate fluctuated from 0.25 percent to 0.50 percent in increments ranging from 25 to 75 basis points. As of February 1, 2023, the current federal funds rate ranges from 4.50 percent to 4.75 percent, which is 4.25 percent more than it was less than a year ago. As the federal funds rate rises, so do the interest rates that banks charge and receive. This may be good news for individuals with savings accounts, but it may result in higher interest rates for credit cards and mortgages. Increasing interest rates make financing operating expenses and asset purchases through debt more expensive for small business owners, severely affecting cash flow. In addition to declining earnings and cash flow, higher interest rates affect valuations' capitalization and discount rates.

When valuing enterprises using an income-based method (capitalized earnings or discounted cash flows), the value is determined by the present value of future profits/cash flow. Depending on the suitable valuation method, the current value of these earnings/cash flows is computed using either a capitalization rate or a discount rate. These rates are frequently established using the same approaches and procedures; a capitalization rate is just a discount rate with predicted growth added on.

The "Ibbotson Build-Up Technique" is one of the most used ways for determining a discount/capitalization rate. In this strategy, an evaluator "constructs" a discount rate by adding many premiums above the "risk-free" rate of return. The result is the required rate of return for an investor, given the inherent risks associated with an investment in the subject company. The "risk-free" rate of return is sometimes equated to the market yield on 20-year constant maturity U.S. Treasury Securities; the 20-Year Treasury yield. The 20-Year Treasury Yield (as of the valuation date) may be the first component in constructing the discount rate. The premiums are then increased to reflect

 the following—increased hazards inherent to the stock market (equity risk premium); Risks connected with investing in a smaller, closely held company (size premium); and Risks unique to the subject company (management depth, access to capital, etc.).

These premiums increase the discount rate; the "riskier" the investment, the greater rate of return the investor will require. An inverse link exists between the expected rate of return and the firm's value, such that a greater capitalization rate will result in a lower company value.

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