Chicago business owners are often required to undergo a valuation for a variety of reasons. Most commonly it is required for transactional purposes, estate and gift tax planning, buy/sell agreements, marital dissolution, or for capital financing. Regardless of the need, a business valuation is a complicated process which examines several data points and assumptions to arrive at a final value. The most common methods used by valuation specialists include the Market, Income, and Asset Based approaches. While each is used under different circumstances, economic factors inevitably impact on the outcome.
Currently, the economy is wrestling with high inflation which has caused the price of food, energy, and other supplies and materials to increase. One way it is being managed by the government is through increasing interest rates. Unfortunately, the combination of rising costs and interest rates can be challenging for Chicago companies. At the same time, it has led many to question how these challenges impact business valuations. To help clients, prospects, and others, Selden Fox has provided an overview of the key considerations below.
- Erosion of Real Value – High inflation erodes the real (inflation-adjusted) value of a business’s assets, revenues, and profits over time. When valuing a business, it’s important to consider the purchasing power of money in the future. A dollar today may be worth more than a dollar in the future due to inflation. Therefore, high inflation can lead to a lower present value of future cash flows and, consequently, a lower business valuation.
- Increased Risk – High inflation introduces additional risk and uncertainty into business operations. This increased risk can impact the discount rate used in valuation models, such as the cost of capital or the required rate of return. A higher discount rate can result in a lower valuation because it reflects the higher perceived risk associated with future cash flows.
- Impact on Costs – Inflation can lead to rising operating costs, such as higher labor, material, and energy costs. This has been seen by the rising costs of materials/ supplies which has forced prices upwards. Businesses may struggle to pass these cost increases on to customers, potentially squeezing profit margins. This can negatively impact the earnings-based valuation methods, such as the Price-to-Earnings (P/E) ratio, and result in a lower valuation.
- Interest Rates and Financing – High inflation can lead to higher nominal interest rates. If a business relies on debt financing, it may face higher interest expenses, which can reduce profitability and impact valuation. Additionally, higher interest rates can make it more expensive for potential buyers to finance an acquisition, potentially lowering the purchase price they are willing to pay.
- Asset Valuation – The value of tangible assets, such as real estate, inventory, and equipment, can be affected by inflation. In some cases, the value of these assets may appreciate, positively impacting the business’s overall valuation. However, it’s essential to differentiate between nominal asset values and real asset values when assessing their contribution to the worth of the business.
- Cash Flow Adjustments – Valuation models may need to incorporate adjustments for inflation when projecting future cash flows. This is particularly important when using discounted cash flow (DCF) analysis. Failing to account for inflation can result in an overly optimistic view of a business’s future cash flows and an inflated valuation.
The reality is the effects of increasing inflation require valuation professionals to more carefully assess how a business will be impacted. Since it will not be the same for all companies, it is important to consult with a qualified valuation advisor to determine how you will be affected. If you have questions about the information outlined above, or need assistance with a valuation, Selden Fox can help. For additional information call 630.954.1400 or click here to contact us. We look forward to speaking with you soon.