Inflation on the rise - quo vadis, business valuation?

What are the benefits and challenges of the traditional valuation approaches in this context?

According to the IMF World Economic Outlook issued in July 2022, global growth is projected to slow from an estimated 6.1% in 2021 to 3.2% in 2022 and 2.9% in 2023 respectively. Macro-economic developments significantly impact commodity and food prices, leading to 2022 inflation projections of 6.6% in advanced economies and 9.5% in emerging market and developing economies.

Developed economies have become unaccustomed to inflation and the current trend therefore makes valuations of illiquid assets, such as businesses, infrastructure and real estate projects even more complex, given the uncertainty related to their cash flow projections. The impact across sectors and geographies varies widely, thereby impacting valuations differently.

Commonly, valuations can be performed based on an Income Approach (e.g., Discounted Cash Flow (DCF) Method) or a Market Approach (e.g. market multiples), each having their own benefits and challenges in the current economic climate.

Income Approach – rising costs, margin compression and increasing discount rates

When valuing a company through the DCF method, expected rather than historical inflation is more important to the valuation, since the intrinsic value lies in the expected future cash flows.

In the DCF method, the impact of inflation can be factored in either via its cash flow projections, or else via discount rate inputs.

In the first case, the valuer carefully analyzes the impact of expected inflation on the company’s future performance, specifically on inputs such as Revenue, Costs and Working Capital. Another critical point of the projections is the difference between Capital Expenditures (CapEx) and Depreciation. Estimating CapEx and investment needs may be challenging in an inflationary environment, where CapEx tends exceed (historical) Depreciation. Generally due to inflation, higher costs for inputs such as raw materials, unfinished products, energy, wages and salaries, put pressure on margins and ultimately on fair value. It must be noted, however, that for certain companies, inflation can be a windfall as prices can be raised and margins can be further consolidated.

For the second factor, the impact of inflation on the discount rate is noticeable through several inputs, such as the Risk Free Rate, Equity Risk Premium, Country Risk Premium and Corporate Default Spread. All of these inputs integrate an inflation component and should thus lead to higher discount rates.

Market Approach – high volatility and lower market multiples as interest rates increase

Along the low interest rates for the past years, we could also observe a period of relatively high market multiples. High inflation and rising interest rates create economic uncertainty, which affects valuations and thus market multiples. The first months of this year saw multiples contracting, although the underlying forces at play may be too complex to already forecast a trend in multiples at this stage. As market volatility tends to have different intensity across regions and industries, valuers have to emphasize screening by analyzing the region and industry criteria in more detail. Doing so should avoid irrelevant comparability and reliance on multiples that may become outdated more rapidly.

“Considering the turbulent geopolitical landscape, soaring commodities prices, higher inflationary trends and interest rates, professionals are facing noteworthy challenges to derive weatherproof valuations.

Given such market challenges, it is important to rely on business valuation professionals with in-depth valuation skills and sound knowledge of the impact of inflation specific to each sector. Our team of over 30 professionals and experts in valuation of private equity, infrastructure, private debt and real estate assets, can help in providing transparent and robust valuations that meet corporate, regulatory and accounting requirements”, comments Christophe Vandendorpe, Partner, Strategy and Transactions Leader at EY Luxembourg.