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How are business valuations impacted in the current economic climate?

Author: ICAEW Insights

Published: 26 Oct 2022

Business valuations are tricky things to tackle at any time, but during the major economic turmoil we’re seeing at the moment, valuing a business is a tough call.

With the UK arguably already in recession and the global economy facing rising interest rates, escalating inflation and a cost-of-living crisis, caution has become a buzzword.

Mature businesses with established market share and revenue are unlikely to face a significant dip in value, but untried and untested technology stocks, particularly new entry tech stocks, have already taken a hammering – they are yet to really demonstrate revenue in any meaningful way or are still loss-making.

High-profile companies such as payments firm Stripe, Swedish buy-now-pay-later firm Klarna and delivery start-up Instacart have already seen their valuations knocked this year. 

Instacart slashed its valuation by 40% as it pointed to market turbulence caused by rising inflation and concerns of a looming recession. In July, Klarna saw its valuation cut by more than 80% to $6.7bn. Last year the fintech business attracted a value of $46bn. 

Reuben Wales, Head of Financial Services, ICAEW, says: “The way that we would typically value a business is by taking a view on its future cash flows, which are underpinned by forecasts. Those cash flows would then be discounted back to reflect that the company is going to realise them at some point in the future. The discount reflects that money held now has a greater value than the same sum to be received at a future date. The discount factor at the moment is going through significant change as a result of rising interest rates.”

Investors will currently be revising their strategies and potentially opting for relatively low-risk investments, such as government securities. Central banks are set to continue to raise interest rates – perhaps not as much as markets are predicting, but rates will certainly rise, which will have a knock-on effect on business valuations. Investors will be increasing their scrutiny on profits and valuations as the turmoil continues.

Wales says: “As we move into a higher-interest-rate environment, driving up risk-free rates, we can expect a larger discount rate. The larger the discount, the lower the valuation of the organisation.”

The impact is already borne out in the number of initial public offerings (IPOs) on the London Stock Exchange (LSE). According to EY, the LSE saw a quiet third quarter, with £565.5m raised by just eight companies – seven times less than the record £4bn raised from 33 IPOs in the same quarter last year.

Scott McCubbin, EY UK&I IPO Leader, says: “The London IPO market has experienced a challenging 2022. Ongoing geopolitical tensions and economic instability, compounded by inflationary pressures, have meant many businesses have delayed their IPO plans until they believe inflation has peaked and stability returns to the market.” 

McCubbin said the outlook for the rest of the year remains subdued. “Companies who may have paused their IPO are now re-evaluating those plans to ensure they can adapt to the new macroeconomic landscape and are ready for the recovery in 2023,” he says.

In the context of high inflation and high interest rates, a period of estimation uncertainty is taking hold. “Investors are trying to think about the future cash flows of a business and its revenues and operating costs, and in this changing economic situation, to what extent can you forecast either of those?” Wales says.

Some companies will be able to pass on price rises to consumers if their product or service is essential, but organisations operating in sectors of more discretionary spend will find it difficult to pass on increases, with households increasingly struggling as a result of the cost-of-living crisis. Moreover, the Bank of England, in order to establish price stability, is actively trying to reduce demand in the economy for goods and services. 

“Organisations within a company’s supply chains and value chains are experiencing similar issues and all of that creates difficulty when assessing cost inputs, how high they might go and the extent to which they might be passed on to customers through price rises. This all adds complexity to business valuations because prospective investors are not thinking about just next year or the year after that. They’re thinking about 10 years’ time.” Wales says.

Experts predict listing activity to rebound in 2023 once inflationary headwinds ease, with business valuations and IPO activity likely to pick up again. But for now, the situation is complicating valuing businesses that are either in need of growth funding or a sale.

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