Recent Increases In Inflation Will Likely Impact Closely Held Business Valuations

From 2012 through 2020, US business owners and investors enjoyed relative price stability. During that period, the annual rate of inflation (as measured by CPI-U) increased within the relatively narrow range of .1% (2015) to 2.4% (2018), with the annual increase over this period averaging 1.6%.

Then came 2021 and the end of the relatively low and stable inflationary environment. Prices, as reflected by the CPI-U index, increased 4.7% in 2021 and have continued the significant increases thus far in 2022. Through October, 2022, the CPI-U index has increased 7.7% on a year-over-year basis – which reflects the largest increase since early 1982.

Economists cite a number of reasons for the recent jump in prices, including (1) the effects of the COVID-19 pandemic, which led to a recessionary period as the result of both short term and permanent business closures; (2) supply chain disruptions which led to a mismatch of declining/delayed supply keeping pace with consumer demand (demand having been somewhat supported by various government stimulus initiatives); (3) labor shortages, leading to increased wages as employers sought to attract and retain employees; and (4) food and energy price increases, partially the result of the Russia-Ukraine conflict.

Higher rates of inflation affect the valuation of closely held businesses in a number of different ways. Specifically, higher levels of inflation directly affect the inputs to the two most frequently applied valuation methodologies – the Income Approach and the Market Approach.

The Income Approach determines a business’s value by discounting or capitalizing the business’s earnings and/or cash flows by a discount or capitalization rate that reflects market rate of return expectations, market conditions, and the relative risk of the investment. In order to derive an appropriate discount or capitalization rate, it is necessary to aggregate (i) a risk free rate (which is typically the rate of longer term US Treasury issues); (ii) an equity risk premium (which is the percent return above the risk free rate that is expected for an investment in equities, given the additional related risk); and (iii) an additional percentage return which would be expected to reflect the additional risk of investing in a company in the relevant industry, generally, and the subject company, specifically.

Increases in inflation tend to: (1) increase the risk free rate, as the rate paid on government bond issues rises during the inflationary period; and (2) increase the equity risk premium, given uncertainty about prospective prices and costs. Company-specific factors will also likely change, depending on the riskiness of the underlying company and the extent to which earnings and cash flows are affected as the result of being able to pass price increases on to customers. All of these factors which are typically attributable to a higher inflationary environment would tend to (i) increase the applicable discount/capitalization rate, or (ii) decrease the earnings/cash flows which are being discounted/capitalized, or (iii) both – resulting in a lower company valuation using an Income Approach during an inflationary period as compared to a period of lower/stable inflation.

A Market-based Approach to determining a business’s value compares the subject company (or interest therein) to similar companies (or interests) which have been sold. Generally, this can be accomplished by a comparison to the shares of publicly traded comparable companies or by analysis of similar privately held companies which have sold. Inflation affects business valuations derived using this Approach by depressing the prices (and related multiples) of shares of stock of publicly traded companies used as comparables for the guideline public company method, and by decreasing the number of M&A deals and related transaction prices (as interest rates rise and financing becomes more expensive) used to determine value using the guideline transaction method. As a result, valuations using a Market-based Approach tend to be lower during periods of higher inflation, all other things being equal.

The impact of inflation on marketability must also be considered. When determining the value of a closely held business interest it is often appropriate to apply a valuation discount to reflect marketability considerations (referred to as a “DLOM”). This discount is intended to reflect marketability/liquidity considerations (such as the time delays of a sale, etc.) of the sale of an interest in a closely held business interest as compared to publicly-traded business interests which may be bought or sold on a national, publicly accessible exchange. Given that an increase in inflation typically leads to a lower number of M&A deals and more expensive financing, any valuation of a closely held business interest during an inflationary period would have to consider the likely impact of a smaller pool of potential buyers and resulting increase to an applicable DLOM.

To conclude, a significant increase in inflation can have an impact on the value determination of a closely held business interest – typically to the downside (a lower value determination) as compared to valuations completed during periods of low inflation and price stability. The extent of this impact can vary – and is often dependent on the subject company and the industry in which it operates.