Since the exceptionally high inflation rate of 10% on average in 2022 (source: CBS), the topic has received a lot of attention. Inflation affects a company's valuation.
For business owners and director-major shareholders (DGAs), it is critical to understand the impact of inflation, as it can affect both the performance and valuation of their businesses.
What is inflation?
Inflation refers to the general increase in prices of goods and services over a period of time. Rising inflation reduces the purchasing power of money, meaning a euro today is worth relatively less than a euro in the future.
Impact on cash flows
One of the most direct effects of inflation on a business is its impact on (future) cash flows. High inflation leads to higher operating costs, such as costs for raw materials, wages and energy. These rising costs can put pressure on a company's profitability unless these higher costs can be passed on to customers.
However, passing on higher costs entirely is not always possible, this depends on market dynamics or through agreed (multi-year) arrangements regarding purchase prices.
Impact on the discount rate
The discount rate, which is used in calculating the present value of future cash flows, is also sensitive to inflation. Higher inflation usually leads to higher interest rates, everyone has seen this with the ECB's increases. This results in a higher discount rate, which lowers the present value of future cash flows. A higher discount rate implies a lower valuation of the company.
Impact on debt and capital structure
For companies with significant debt, inflation can have a mixed effect. On the one hand, inflation can reduce the real value of fixed debt payments, which can be beneficial to the debtor.
On the other hand, rising interest rates due to inflation can lead to higher interest expenses for existing variable rate loans or in the case of a new fixed-rate period of outstanding debt. Higher interest expenses can negatively affect cash flows, and thus the valuation of the company.
Strategic adjustments
To manage the impact of inflation, entrepreneurs and DGAs can consider several strategies:
Analysis and rationalization: A (renewed) analysis on the different product and service groups can provide insights regarding the overall revenue model. Certain groups may deserve more attention, while it may also be advisable to discontinue certain activities or focus more sharply on the profit contribution.
Pricing strategy: make price adjustments to offset higher costs. Of course, there should be good visibility as to whether this does not (significantly) reduce customer demand.
Cost management: taking proactive measures to optimize gross margins, for example, by seeking cheaper suppliers, or controlling operating costs, for example, by implementing more efficient processes or seeking alternative, cheaper suppliers.
Working capital optimization: This will provide lower interest costs (through lower capital utilization) but can also help reduce warehousing/trading costs. In doing so, proper management of working capital is desirable to allow for controlled future growth.
Conclusion
Inflation has a significant impact on the valuation of a business, primarily through its effects on cash flows, discount rates and interest expenses. It is essential for business owners and CEOs to be aware of the various effects of inflation so that they can take strategic measures to mitigate the adverse effects of inflation.
By proactively analyzing, developing and implementing pricing strategies, optimizing cost control and working capital, among other things, businesses can better position themselves to meet the challenges of an inflationary environment and maintain or even increase their value.
