Declining economic conditions: Impact on business valuation (2)
Economic conditions have critical impact on business valuation and inflation plays an important role in a company’s financial situation, influencing how investors and professional valuers approach corporate valuations.
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An analysis of the 2022 performance of stock exchanges around the globe demonstrates how investors are looking at profitability and how they value businesses in tough economic environments.
Periods of economic instability usually usher in weak consumer confidence. Consumer confidence is another important factor affecting the demand for consumer goods and overall profitability of a business.
During times of economic buoyancy, consumers are more likely to purchase higher amounts of goods and services as they feel confident about the economic outlook and their personal finances; this bodes positively for businesses as revenue grows faster.
During high inflationary periods, however, businesses face higher input costs resulting in weaker margins.
Since the discounted cashflow model derives the value of a company based on the amount of cash/income remaining after the entity has settled all the cashflows required to run its operations, working capital and capital expenditure, declining margins impact stock price and business valuation adversely.
Therefore, business value is eroded when the economic outlook is gloomy.
The cost of running business operations (rent, utilities, cost of production) rises as inflation increases.
This becomes another constraint for business owners as they must consider strategies to transfer higher cost to customers, if and where possible. If costs reach unbearably high levels without proportionate rise in revenue, the company’s valuation is impacted.
The table below shows the impact of rising inflation and interest rate on business valuation.
Business indicator: Impact of rising inflation and interest rate on business valuation
Revenue: All other things being equal, rising inflation affects total revenue negatively as increase in prices of goods and services leads to reduced demand by customers.
However, businesses that produce and sell inelastic goods and services (such as consumer staples and utilities etc.) may not be affected by rising inflation as the demand for such goods and services are less sensitive to price changes.
For customers that depend on borrowing for consumption, rising interest rate leads to higher borrowing cost thereby negatively impacting volume of goods and services they can purchase.
This means businesses will record lower sales, reducing overall business revenue.
Lower revenue affects business valuation, value in use (VIU) and fair value less costs of disposal (FVLCD) negatively as this is likely to lead to lower net income and free cash flows.
Operating cost: Inflationary pressure can lead to increased costs for businesses including labour, materials, overhead and energy. Companies that are unable to transfer higher costs to customers through higher prices would face the issue of lower profitability.
Higher operating costs without a corresponding increase in revenue has a negative impact on business valuation. This is because, costs represent outflows to the company and a deduction from revenue, hence a reduction to the firm’s free cash flows.
A discount rate is a rate that is used to determine the present value of a future cash flow. It may be referred to as the company's cost of capital (debt and/or equity).
Discount rates are typically calculated using the Capital Asset Pricing Model (CAPM) and Weighted Average Cost of Capital (WACC) formulae.
There is a negative relationship between discount rate and the overall value of the discounted cash flow model in that higher discount rates lead to lower business value, VIU and FVLCD.
This also applies to the valuation of assets tested for impairment, including intangible assets such as goodwill.
Businesses will need to revisit and update their cash flow assumptions to counterbalance this decline in value; otherwise, there is a higher likelihood of impairment.
We have discussed how rising interest rates and inflation impact each component of discount rate below:
Discount rate (Cost of Capital)
Risk-free rate: Risk-free interest rates are the foundation of discount rate calculations used in discounted cash flow models. The risk-free rate is the rate of return on an investment with zero risk.
The rate usually moves in the same direction with inflation and benchmark interest rate because interest rates are the primary tool used by central banks to manage inflation.
As such, all other things being equal, higher risk-free rates lead to higher discount rates and vice versa.
Country risk premium: Country Risk Premium (CRP) is the additional return or premium demanded by investors to compensate them for the higher risk associated with investing in a riskier foreign country, compared with investing in a less risky domestic market.
There are three methods of calculating CRPs:
• Default spread of country: This method calculates CRP for a specific country by comparing the spread on sovereign debt yields between the country and a mature market, such as the United States.
• The equities volatility-based technique. This calculates CRP based on the relative volatility of equity market returns between a certain country and a developed country.
• A hybrid approach: It combines the above two methods.
All other things being equal, when using the default spread approach to determine CRP, a higher interest rate could imply a higher country risk premium and vice versa, since interest rate have a positive relationship with bond yields.
Furthermore, since higher interest rate negatively affects earnings and share prices as future earnings from shares become less attractive when compared to bond yield, it is arguable that higher interest rate environment can account for higher equity volatility of the local equity market when compared with the developed market (assuming the developed market is experiencing stability).
Consequently, higher interest rate is expected to result in increased CRP, all other things being equal.
Equity risk premium: Equity Risk Premium (ERP) is the excess return earned by a stock market investor over a risk-free rate.
Depending on how it is measured, equity risk premium could have a positive relationship with interest rate and while this relationship may vary over time, we have observed that ERP has risen with interest rate since 2021.
Cost of debt: Cost of debt simply refers to the company’s cost of borrowings i.e. the return that a company provides to its creditors and borrowers.
It is usually derived by adding a spread over the current risk-free rate to account for the default risk related to the entity raising the debt. As such, a higher risk-free rate leads to higher cost of debt.
Based on the above, we expect a higher discount rate in a rising interest rate/inflationary environment, implying a lower business value, VIU and FVLCD.
Hence, the likelihood of impairment loss is increased when recoverable amount is compared with the assets’ carrying amount.
The writers are Partner and Financial Advisory Leader, and Manager and Team Lead, Valuation & Modeling,
Deloitte Ghana