Over the past eighteen months, consumers have become accustomed to or reacquainted with the impacts of inflation on our daily lives. For business owners, inflation has created a need for balancing the ability to pass additional costs onto customers or restructure to mitigate the impacts of rising prices. The concept that high inflation impacts the valuations of a company should come as no surprise. In this article, we examine the impacts of inflation on business valuations and how valuation experts incorporate the impacts of rising prices into the analysis of the fair market value of a company.
What are the recent statistics on inflation?
In June alone, the Consumer Price Index (CPI) for all items rose 1.3%. Over the 12-month period ending in June 2022, consumer prices are up 9.1% (the largest annual increase in 40 years). This increase varies for certain goods; for example, select fuel and oils are up 70.4% over the last 12 months[1].
How does inflation impact the operations of my business?
For your business, sustained inflation may cause a rise in direct costs, as well as broad business costs. For non-essential businesses, a devastating effect of inflation is lower customer demand for discretionary goods and services, leading to lower profits. Oftentimes, essential businesses can maintain their profits by passing these cost increases onto customers. In addition, companies may see a rise in overhead expenses, such as long-term lease agreements that contain escalation clauses tied to inflationary measures. Vendors and professional service providers to your business may also increase their prices during times of inflation. Furthermore, wage increase demand can create upward internal pressure to retain skilled labor in an extremely tight labor market. The rising cost of living for lower wage employees could result in turnover for more expensive employee alternatives.
Is inflation going to affect the value of my business?
There are two major pressures that impact a business valuation as a result of inflation. The first pressure is internal or company-specific costs. The second pressure is macroeconomic risks.
Internal or company-specific inflationary pressures include increased costs, negative impacts specific to the industry, and the company’s ability to pass off price increases to its customers. In short, if inflation is impacting the profitability of a company and the business is unable to pass its increased costs to customers, the business is going to be worth less. For a business to maintain or increase its value, it must be growing. When inflation slows the business’s growth, it negatively affects the projected growth rate applied to the business (the projected growth rate is the most sensitive attribute of any valuation model). Additionally, a valuation expert may place a higher discount on a company that is more sensitive to inflation. Adding additional discounts associated with the risk of a company reduces the value.
External or macroeconomic factors can also impact a company’s valuation. Key factors include the rising cost of interest rates (cost of debt) on borrowings, labor scarcity, input costs, and supply chain bottlenecks. If a company’s profitability can be greatly impacted by economic factors to which the company has no control, the risk profile and discount or capitalization rate are likely to increase—resulting in a lower valuation.
From a valuation perspective, experts should be analyzing businesses based on forecasted data and thoroughly examining the levers of their model that are tied to economic conditions. Considerations should be made and incorporated into the valuation model for rising prices and the stabilization of inflation in the near term. When valuing a business using historical cash flows, the valuation should factor in the current economic conditions as well as address the likelihood of historical cash flows to be sustainable in an inflationary environment.
How can I guard the value of my business from the effects of inflation?
The key to maintaining the value of your business during periods of rapid inflation is profit protection. Businesses are valued based on their ability to generate cash flows, and a business is sold based on the expectation that it will generate future profits. The more cash flow a business can generate and secure, the more it will be worth.
Creating a detailed accurate forecast that accounts for expected price and cost inflation in future cash flow projections is essential. Accounting for the inflation component is imperative to identifying the appropriate levers the company can control. Having conversations early with customers and suppliers about increasing prices can allow a company to make quick decisions and put them in the best position to succeed.
For any questions related to the impact of inflation on business valuation or, for guidance related to business valuation services, please contact Bryan Setz, CPA CVA CFE, at bsetz@vlcpa.com or 800.887.0437.
[1] United States monthly inflation rate June 2022 Published by Statista Research Department
