This year the U.S. is experiencing record-high inflation due to several significant global economic and political factors. The impacts of this inflation are most easily and directly felt by consumers at the gas pump or the grocery store, but for business owners, the impacts run much deeper. Current inflation or the threat of continued significant inflation have substantial impacts on company valuations. Below are 3 considerations for owners as you try to make sense of a rapidly changing economy.
- Lower Margins – Since inflation reduces the buying power of the dollar, there is a natural increase in the cost of goods and services. Passing on these increased costs to customers through pricing is challenging and often a lagging event at best. This has a negative impact to the business margins, at both the gross profit and operating profit levels. Since many businesses are valued based on a multiple of earnings, reduced margins means a lower base to apply a multiple and therefore a lower overall business valuation.
- Future Cash Flow Risk
- Rising inflation and volatile markets create uncertainty for investors and buyers. This increased uncertainty factor generally drives market multiples down. The earnings multiple generally represents the potential long-term return of an investment. De-risking future cash flow tends to drive multiples up, so it’s only natural that increasing risk of future cash flow would bring multiples down. As the multiple goes down, so does the business valuation.
- Number of Buyers
- In times of significant inflation and market change, capital allocation models change rapidly. Suddenly, available cash and liquidity are shifted towards buying fixed income investments instead of equity. Buyers tend to go into a conservative holding pattern and wait for certainty and signs of recovery. This means that the overall pool of potential buyers for a business could be reduced. Without adequate demand or a traditional “bidding war”, a business won’t reach the same value it otherwise would.
Despite the heartburn caused by rising inflation and market volatility, there are still many strategies owners can implement to position their business for success and preserve enterprise value. Revisiting pricing strategy, financial modeling, cost reduction, benchmarking, and leveraging key advisors are all great tools to combat the negative impacts.