It seems like every day there’s a new article about inflation hitting a 40-year high and its effects on everyday life. Whether it’s rising vehicle and real estate prices, rising labor costs, or $6-7 eggs, the impact of the COVID-19 pandemic continues to affect our lives. Because many of these effects appear to be less transitory than economists initially predicted, business valuation professionals must consider how these conditions affect valuations.
For most of 2020 and 2021, many business analysts excluded 2020 operating results in their analysis of continuing earnings. The assumption was that the complete closure of some businesses and the cascading effects across industries could be seen as a “non-recurring” impact on cash flows. However, some businesses have benefited greatly from certain aspects of the pandemic. For example, companies with ready stocks of cleaning supplies or personal protective equipment experienced significant increases in revenue and profits. As with companies experiencing a downturn due to the pandemic, these high revenue and profit levels were not expected to last.
Now that we’re three years into the pandemic, it’s time to acknowledge that many companies are operating in a new reality defined by reduced profits and higher interest rates. How do these two key factors combine to reduce business valuations, especially in closely held companies, which are often at the center of matrimonial cases?
Decrease in earnings/cash flow
Inflation in 2021 and 2022 was at its highest level since the early to mid-eighties. This elevated inflation can be directly traced to the long-term effects of pandemic-imposed shutdowns, supply chain disruptions, overwhelmed ports, labor shortages, and limited energy resources. While there is disagreement about the relationship between these factors and whether federal policies play a role, there is no doubt about the end result: higher prices for nearly every good or service. These increases are not limited to the final consumer product; they have also affected the cost of doing business. It is the compounding effect of the rising cost of basic materials and services that causes this extreme change in consumer prices.
While businesses try to pass these higher costs on to consumers, there is always a limit to what customers will accept. In many cases, businesses have experienced reduced margins and profits. With labor in particular, wages have outpaced income growth due to market wage adjustments, new hire signing bonuses, higher starting salaries, a rising minimum wage and a general shortage of workers. For companies with flat or minimal incremental revenues, these higher costs directly reduce the profits available to business owners. At the most basic level, a decrease in earnings equals a decrease in the value of the company.
Increasing/Variable Interest Rates
To combat runaway inflation, the Federal Reserve began an aggressive policy to raise the federal funds rate. Eight times since March 2022, when the federal funds rate moved from 0.25% to 0.50%, the Fed has raised its target rate in increments of 25 to 75 basis points. The current federal funds rate is 4.50% to 4.75% as of February 1, 2023, up from 4.25% a year ago. As the federal funds rate rises, so do other interest rates charged or paid by banks. While this is good news for those with savings accounts, it also means higher rates on credit cards and home mortgages. For small business owners, rising interest rates make it more expensive to finance operating expenses and purchase assets through debt and negatively impact cash flow. In addition to reducing earnings/cash flow, rising interest rates affect 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 flows. The present value of these earnings/cash flows is determined either by the capitalization rate or the discount rate, depending on the appropriate valuation methodology. These rates are often determined using the same methodology and procedures – the capitalization rate is essentially a discount rate adjusted for expected growth.
One of the most common methods for determining the discount/capitalization rate is the Ibbotson Build-Up Method. In this method, the appraiser “builds” the discount rate by adding several premiums above the “risk-free” rate of return. The result is the rate of return required by the investor due to the risks involved in investing in the subject company. The “risk-free” rate of return is often considered equal to the market yield on US Treasuries with a fixed maturity of 20 years; 20-year Treasury yield. The appraiser may use the 20-year Treasury yield (as of the date of valuation) as the first component in forming his discount rate. Additional rewards are then added to reflect:
- Additional risks specific to the stock market (equity risk premium);
- Risks associated with investing in a smaller, closely held business (scaled reward); and
- Risks specific to the subject company (depth of management, access to capital, etc.).
These premiums increase the discount rate; the “riskier” the investment, the higher the rate of return the investor will require. There is an inverse relationship between the expected rate of return and the value of the company – a higher rate of capitalization will create a lower value.
As of December 31, 2021, the 20-year Treasury yield was 1.97%. The 20-year Treasury yield rose to 4.59% in October 2022 as the Fed hiked rates through 2022. As of January 31, 2023, it was 3.78%. As a result, depending on the date used, the appraiser may use a capitalization rate of between 1.81% and 2.62% than it would use at the end of 2021.
An example of how this can affect a company’s value. Assuming cash flow of $100,000, the business would be valued at $666,667 at a 15% capitalization rate. Increasing the capitalization rate by 1.81% will result in a value of 16.81% to $594,884, and an increase of 2.62% to 17.62% will result in a value of $567,537; 11% to 15% decline in value based solely on rising interest rates.
|Capitalization rate||15.00 %||16.81%||17.62%|
In general, it is important to remember that income-based valuation is based on the expected future profits/cash flows of the operating entity. Although we as appraisers often rely on historical earnings to determine future earnings, it is important to consider market and operational changes in our analysis. The ongoing effects of the COVID-19 pandemic, along with the appropriate government response, have created significant changes in operations and markets for many companies. Given that these effects continue today, it is important to closely examine changes in operating results over the past two years and adjust accordingly.