Chuck Faunce, Director, Business Valuation & Litigation Support recently authored a guest article for Mergers & Acquisitions Magazine titled, “The Impact of Inflation on the Value of Your Business and What You Can Do About It.” In addition to providing a deep-dive into the topic in this GSG podcast interview, we are offering the following Q&A interview with Chuck – as an ideal informational resource for any company owner worried about protecting business value and managing the impact of inflation.
Q. Please give us a high-level overview of what you covered in your recent Mergers & Acquisitions article.
Faunce: As part of my effort to understand the businesses I value, I ask owners a lot of questions about how and why they make the decisions they make. We talk about attracting and retaining customers and employees, differentiating from competitors, reasons for charging higher prices and ways they can reduce costs.
All of those things have a lot of moving parts, but one thing that didn’t require much thought was what the effect in the change in the value of money might be, because for many years, the value of money didn’t change much — inflation was both low and stable, which is ideal for business decision making. Inflation complicates decision making if it’s volatile or high or both because it increases uncertainty around demand and margins and increases the cost of capital.
My goal with the article in M&A magazine was to identify a simple structure dealmakers could use as a starting point to understand the risk inflation poses to cash flows of portfolio or target businesses by considering its effects on a business’s marketing, operating and financial characteristics.
Q. Overall, how can the rise in inflation impact the value of a business?
Faunce: The value of a business is a function of the cash flows it’s expected to generate in the future and the cost of capital it needs to achieve those cash flows.
Inflation can impact expected cash flows through its effect on demand. If a business has sufficient pricing power inflation could result in higher revenues. The extent of a business’ pricing power is affected by things like the availability of substitutes and level of competition and depends on issues such as the extent to which customers consider a product or service to be either a commodity or differentiated, and also either discretionary or non-discretionary.
Inflation can impact a business’ cost of capital by increasing the uncertainty with regard to the timing and amount of its expected cash flows. The impact manifests itself in two ways.
First, the costs of both debt and equity go up because investors require returns in excess of the risk free rate, and inflation increases the risk free rate. Second, as the cost of debt increases, things like interest coverage ratios may decrease and that makes it more difficult for a business to access the next marginal increment of debt.
That results in capital structures with relatively more equity and less debt and, since equity is more expensive than debt, that results in a higher weighted average cost of capital
Q. Tell us how dealmakers can better understand the risks posed by inflation (i.e., the simplified model)?
Faunce: Even simple businesses are complicated so it can be hard to know where to start. However, all businesses have to do three things – first they have to sell their products and services, then they have to produce their products and services, and finally they have to keep track of it all. So, all businesses perform marketing, operations and finance activities.
The article suggests using this as a starting point to begin to understand what specific activities are involved. Once specific activities are identified it becomes a little easier to understand if and how they can be managed to impact revenues and costs.
Q. What can businesses do to get a better handle on inflation and increase their value?
Faunce: They can start by getting a better handle on their marketing, operating and financial characteristics. Marketing characteristics include potential and targeted market segments, and positioning in terms of each products’ or services’ features, pricing, promotion and distribution.
Operating characteristics include product and service development and delivery, staff attraction, retention and development, capacity management and quality control.
Financial characteristics include measurements of profit, asset and risk management that inform the analysis of marketing and operating characteristics in addition to purely financial considerations such as cash and capital management decisions.
Really the time to prepare for high or volatile inflation is before it starts – now that we’re in the thick of it. Businesses are forced to be more reactive than proactive, and what businesses can do to mitigate the effect of inflation depends on the characteristics of the business and the period of time for which high or volatile inflation is expected to last.
That being said, working through a simplified model may identify some low hanging fruit – maybe a particular product line that’s more sensitive to inflation can be marketed differently, or maybe short term changes can be made to some operating characteristics without incurring too much of a long term penalty, or maybe higher required returns reduces the number or amount of investments in the short term.
Q. Tell us about GSG’s business valuation services?
Faunce: GSG provides accounting, tax and consulting services like business valuation to small and middle market clients in a broad range of industries. We’ve earned our role as a trusted advisor by developing deep relationships with our clients since 1934. We provide valuations in support of transactions, litigation and tax and financial reporting compliance and have significant valuation expertise with companies in the manufacturing, service, retail and wholesale, construction, health care and other industries.
Q. Anything else to add?
Faunce: Not all models are created equal, but having a model is better than not having model because having a model allows you to get started on the analysis and getting started is half the battle.
Inflation, Small Business, Valuation