As businesses navigate increased costs from vendors and employees, many wonder how inflationary pressures will affect their value or price in the marketplace.
The value of a business is primarily based on three factors: 1) earnings, 2) the risk of achieving those earnings, and 3) the expected growth of earnings. Some businesses have pricing power—the ability to pass on most or all increased costs to the consumer, allowing revenues to grow alongside expenses. For many businesses lacking pricing power, increased inflation impacts all three factors mostly negatively, affecting the value of the business.
During inflationary periods, companies that have pricing power are better able to weather increased costs. These companies generally sell goods or services that are either necessary to the consumer or that dominate their market.
For most other companies, increased input prices may not be able to be passed through to the consumer, and therefore must be absorbed by the business. In addition to increased prices of materials and supplies, labor costs have gone up due to labor shortages, as employers look to increase wages to attract and retain employees. Both these conditions shrink profit margins and in turn tend to reduce a business’s value.
To value a business, economic, industry, and company specific risks are quantified in terms of a discount rate used to compute the present value of the future cash flows of a business. The riskier a company’s earnings are, the higher the discount rate, which tends to lower the value of the company. In today’s economy, the Federal Reserve has made multiple increases to the Federal Funds Rate. This has caused the risk-free rate, a component of a business’ discount rate, to increase. This tends to lower the value of many companies, all else being equal.
In addition, higher inflation causes uncertainty as to the future prices of goods and services. This uncertainty increases risk and thereby causes buyers to pay less for businesses because they are protecting themselves from risk through the pricing mechanism. Alternatively, when prices are stable, as they have been over the last twenty years, inflation risk is generally not considered in the determination of a business’s value. Because price stability is no longer considered a given, inflation risk is now being considered as a risk factor that would tend to lower valuations.
Some companies have greater needs to re-invest earnings to grow than others. For those companies, the risk related to uncertainty about future inflation leads to reduced investment, as it becomes harder to justify large upfront investments. With the Federal Reserve raising its benchmark interest rate multiple times during 2022, the cost of borrowing has increased, potentially hampering growth for many companies which utilize debt to fund asset purchases. Increased price uncertainty coupled with an increase in borrowing costs are recipes for slower growth compared to non-inflationary periods.
Dealing with Inflation
Here are some thoughts to consider when dealing with rising prices, and hopefully positively influence business value:
- Assess your business’s fundamentals including such items as its liquidity, operating activities, leverage, price elasticity, and expense levels.
- Develop a strategy that takes into consideration a possible prolonged period of rising prices and costs. Forecast how that might look and develop a plan to raise prices and reduce expenses sufficiently to maintain profitability. Acknowledging inflation will enable having proactive conversations with clients and vendors about controllable aspects of your business.
- The strategy should include modeling how to respond to variability in client and vendor behavior, lack of availability of critical resources, new and additional needs to manage and engage with the company’s talent and workforce, leveraging technology to enable future growth, etc.
- Lastly, professionals such as bankers, attorneys, and accountants can be of assistance in accessing the strengths and weaknesses of your business and in developing strategies to implement as you confront these uncharted waters which we are all experiencing.
You don’t have to traverse these waters alone. The team at MarksNelson can help your business develop a plan to navigate the inflationary currents, to keep your business on course in its market value. Contact our team today.