Throughout 2021 and 2022, inflation has ramped up significantly. In June 2022, the Consumer Price Index (CPI) was up 9.1 percent from June 2021, representing the largest twelve-month increase in the CPI since 1981. As inflation takes hold and fiscal and monetary responses have attempted to slow it down, it brings up the question of how it impacts business value.
Before discussing how inflation affects the value of a business, it is important to understand how businesses are valued. Intuitively, a business is valued by projecting the benefits it is expected to generate (typically in cash flows) and adjusting for the risk associated with achieving this level of benefits. The higher the benefits, the higher the value of the business, and the lower the benefits, the lower the value of the business.
If inflation impacts all areas of a business and the economy equally, high inflation will increase the dollar value of a business. This is because the benefits the business generates will increase without any effects to risk. However, since inflation has increased the price of goods and services across the board, the real value of the business will stay the same. In other words, the business’s value in U.S. dollars will be greater, but the purchasing power of those dollars will still be roughly the same due to inflation.
Unfortunately, inflation is rarely equal across all sectors. For example, while twelve-month inflation for all items hit 9.1 percent in June, inflation was 10.4 percent in the food category and 41.6 percent in the energy category, due largely to the effects of Russia’s invasion of Ukraine. On the other hand, over this same time period, inflation was 5.2 percent in the apparel category and 4.8 percent in the medical care services category. Therefore, while a U.S.-based energy company would probably see a significant spike in business value solely due to inflation, a U.S.-based apparel company likely would not reap this benefit.
Additionally, depending on a business’s revenue and cost structures, inflation can have different effects on value. While some businesses may see proportionate increases in both their revenues and their expenses, this is not always the case. For example, a business in an extremely competitive market may not be able to raise its prices to match large inflationary increases in expenses. In this case, higher inflation could potentially decrease the value of a business. As a result, it is important to consider the impacts of inflation on a case-by-case basis, evaluating each part of a business to determine what impact inflation will have.
In response to the high inflation over the past year, the Federal Reserve has progressively been increasing the target Federal Funds Rate. After dropping the rate target to 0.00 percent to 0.25 percent in March 2020, the Fed has been ramping it up over the past few months to 2.25 percent to 2.50 percent in July 2022. This is meant to put the brakes on runaway price increases, and therefore may serve as a counterbalance to inflation-based business value increases. Also, rising interest rates will serve as a significant drain on cash flows for businesses that rely heavily on debt financing, potentially hindering liquidity and the ability to reinvest in the business.
These actions by the Fed appear to have been having some effect. In July, inflation slowed to 8.5 percent over the past twelve months, and the CPI was unchanged on a seasonally adjusted basis from a month ago. Future rate hikes are expected to continue, with the Federal Open Market Committee members estimating that the Federal Funds Rate target will reach 3.25 percent to 3.50 percent by the end of 2022.
Additionally, the Inflation Reduction Act of 2022, which has passed both houses of Congress and been signed into law, will further serve to hamper inflation through provisions designed to lower energy and prescription drug costs. Therefore, while inflation is still soaring above historical levels, there are indicators that it is beginning to slow and may continue to slow in the future.
The inflationary economy we are currently experiencing is likely to continue to impact how businesses are valued for the foreseeable future. However, it is important for business owners to understand the full picture in regard to how inflation impacts their business and to act appropriately. Monitoring cash flows and paying attention to multi-year projections can be a good way to stay ahead of an inflationary economy. Without proper diligence a business could find itself sitting in the wrong seat on the inflation roller coaster.
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