Inflation and climbing interest rates have been discussion topics for well over a year. We are all too familiar with their impacts in the form of higher prices for everyday goods as well as higher loan payments for home and auto purchases. Even the stock market has felt the effects significantly.
Why are these large corporations losing value? And what does it mean for the value of private businesses? What should business owners do?
We need to first understand what drives business value. While countless variables exist, we can group them into three primary drivers of value:
1. The expected earnings/cash flows from a business’s operations.
2. The expected future growth of those cash flows.
3. The riskiness of achieving those cash flows and/or growth in cash flows.
Together, these variables allow us to forecast future cash flows and to calculate the present value of them. This present value is the price a buyer would pay today for the right to receive future expected cash flows. When risk is high, investors require a higher percentage rate of return, which results in a lower present value.
Inflation might or might not have an impact on the riskiness of achieving cash flows/growth. This largely depends on a business’s pricing power and ability to pass on rising costs to consumers. Uncertainty in pricing power can lead to higher risk and lower values.
The bigger factors impacting risk tend to be what happens as a result of inflation.
That brings us to interest rates.
As the Fed increases interest rates, businesses pay more in interest expense, which reduces cash flow and decreases stock prices. Additionally, as interest rates increase, businesses tend to borrow less, which might delay growth plans. Again, less growth means less value.
But the most significant impact that comes from interest rates might be due to risk.
As interest rates go up, default risk increases. This risk flows through to the business, and its investors require a higher return on their investment for taking on this higher risk.
Furthermore, as the Fed increases interest rates, concerns about economic recession and job losses can compound the issue, causing investors to seek safer investments or require higher returns through lower prices. As rates of return increase, the net present value of future cash flows decrease, which decreases value.
So, what are private business owners to do?
First of all, declining business values aren’t always a bad thing.
Families looking to transition their business to the next generation and minimize estate taxes can take advantage of lower business values by gifting stock to their kids. A lower business value means you can gift more of your business before having to pay Uncle Sam.
But for those interested in maximizing the value of their business now, paying down high-interest debt can be the first step to increase cash flow and help to mitigate default risk.
However, maintaining a long-term outlook is still important.
Debt can help a business grow faster than it would otherwise. Failing to invest in growth can lead to lost market share when the economy recovers.
Finally, de-risk your business as much as possible. Implement a good work culture and have a good system of policies and processes to help keep the company running efficiently. Have a reliable system of financial reporting to stay on top of your business, cut costs, forecast future earnings and track changes. Discuss concerns with your trusted financial advisors.