In our current economic climate, it’s important to understand how inflation and high interest rates impact business valuations. In 2023, as the fed continues to increase interest rates in an attempt to slow inflation, it’s vital to ensure any closely held business interests owned in trust or IRA accounts have updated fair market values.
Changes in interest rates can have a significant impact on business valuations, so when you are looking at your client’s portfolio, there are two main issues to consider: earnings & cash flow, and increase in the cost of capital & discount rate/capitalization rate.
How Inflation and High Interest Rates Impact Business Valuations:
Impact of Inflation on Earnings & Cash Flow
Inflation can affect profits by increasing a company’s costs, which will have a direct impact of gross and net profits if sales prices are not increased. If a company does not have pricing power, they may be forced to keep their sale prices the same during a period of inflation, which will cut into their margins. Furthermore, inflation and higher interest rates can lead to lower consumer spending, as people may have less disposable income to spend on goods and services. These factors can impact the overall health of the economy and, in turn, business valuations.
Inflation Increases the Cost of Capital
When interest rates rise, the cost of borrowing money increases. Whether it is debt capital or equity capital, the increase in the cost of capital may make it harder for companies to raise additional money, to finance operating expenses, and make asset purchases. The increase in interest rates not only influences the ability to raise capital, but it also affects the cost of capital in valuation theory. In business valuations, the cost of capital is synonymous with the discount rate and is the primary driver of the capitalization rate.
When interest rates rise, the cost of capital increases, and impacts the discounted cash flow (DCF) method and the capitalization of cash flow method. The DCF method is a commonly used valuation method that calculates the present value of a company’s future cash flows. As rates increase, the discount rate used in the DCF calculation also increases. This means that the future cash flows of the business are worth less today, which can lead to a lower valuation. The capitalization method applies a capitalization rate to a single period economic measure to convert that measure to a value indication. The capitalization rate utilized is comprised of two main components: a discount rate and a long-term growth rate. Just like the DCF, as the discount rate increases, the cash flows of the business will also decrease, which can lead to a lower valuation.
So, how can you help your clients that own or invest in businesses prepare for the impact of higher interest rates on business valuations? It is important to help them plan ahead. It may be necessary to adjust financial strategies to minimize potential impact. Look at their goals and other growth investments and the portfolio as a whole and focus on the long-term.
It is important to work with a qualified appraiser who understands how inflation and high interest impact business valuations. ITM offers valumonitor, a set of business valuation solutions to address the compliance and reporting challenges professional trustees face. Our team of qualified appraisers derive an unbiased determination of value intended to help fulfill your fiduciary obligations. For more information, please contact us.