The effects on inflation on consumer’s spending and psyche are well know. The difficulties each causes in everyday life are often discussed. Inflation has effected everything in people’s daily lives, from the cost of transportation to the cost of food and housing and, consequently, on habits. Less discussed, however, is how the current inflationary period affects small, medium and large business owners and their companies.
Calculated annually, the inflation rate reflects the average percentage by whitch the price of a specific basket of good and services purchased in different countries around the world. The Federal Reserve in the US or the Central Bank in Europe uses the inflation rate as a key indicator of economic growth and stability.
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Inflation rate trend
The year 2022 was marked by a sharp increase in inflation, unprecedented in the last 20 years at national, European and global level. The inflation rate (Source: IMF, International Monetary Fund) reached 9.2% in Europe, 8.7% in Italy, 8.1% in the US and 8.8% worldwide.
The impact of inflation in business valuation
There are three drivers that impact the value of a company: a) the cash flow, b) the growth (or “g”), c) the risk. Therefore:
value = cashl flow*(1+g)/risk
To measure the impact of inflation on business valuation, we need to analyze the impact of inflation on thees three key-drivers. It is good to anticipate, however, that history teaches us that the impact on value is relevant if inflation is both high and persistent and not only high but short-lived.
- Impact of inflation on cash flow
The Cash flow is the main parameter of economic benefits. So, how does inflation affect cash flow? The general rule is that when inflation is high, firms raise prices to consumers whose reaction is reflected in lower demand. Consumer’s reduced spending has a direct effect on a company’s revenues and profits. Since cash flow is the direct result of income or profits, it is logical that high inflation has a negative effect on cash flow. As a result, it is safe to assume that the company’s value will also decline. McKinsey (a multinational strategy consulting company), in fact, believes that inflation reduces the real value of the cash flows that companies are able to generate because they cannot increase prices (without reducing sales) at the same rate as their costs, both operating and financial, increase.
- Impact of inflation on growth (g)
When evaluating whether to invest or purchase ownership stakes in a company, one of the most essential factors investors consider is the firm’s sustainable growth rate. Due to the prospective nature of valuation, knowing the company’s long-term development prospects is essential for any interested party. curbs the company’s expansion potential as it increases direct and indirect expenses. The combined effects of slow growth and reduced sales erode the company’s value.
- Impact of inflation on risk (discount rate)
The cost of capital, often known as the discount rate, is the third value driver that may influence the value of a firm. Methods such as the Capital Asset Pricing Method (CAPM) and the Weighted Average Cost of Capital (WACC) are examples of some of the approaches that may be used in business valuation to calculate the discount rate.
An increase in the risk-free rate, or the risk-free rate of return over a long-term time horizon (in most cases for valuations, a 10Y Bond is preferred because it is (i) sufficiently large to reduce the effects of short-term volatility and (ii) better reflects the duration of a business cycle) as well as an increase in the cost of equity and the cost of debt, are where inflation can have an effect on the discount rate.
These rates tend to go up whenever inflation does, and as a result, the cost of obtaining funds increases as well. The risk profile of the company is reased and makes it unattractive to investors.
When the discount rate is higher, the value of the company is negatively impacted, which means that the value of the company is lowered. The value of an economic asset, in fact, is equal to the value of the cash flows it will be able to generate in the future, discounted (as of today) at a rate that is representative of the cost of risk and the passage of time; the higher the (real) cost of capital, the lower the present value of these cash flows and, consequently, also the value of the asset being valued.
Conclusion
In the event of inflation, a company’s actual earnings decrease, since one euro can be used to purchase a smaller amount of products and services. In other words, inflation represents a hidden tax.
It is specified, however, that as long as the economy is able to cope with rising rates and inflation does not prove to be persistent, there will be no significant negative impact on the value of economic activities. Therefore, constantly monitoring the currently highly unstable inflationary trend (and to be added that of risk free rates) and the global economy, is a dominant factor for a correct business valuation.
