Inflation can have a negative impact on the value of your business but there are strategies you can use to mitigate its effects.
Higher inflation negatively impacts on financial assets while having a neutral/positive impact on gold, collectibles, and real assets. The impact of inflation and price changes on individual company values, on the other hand, can vary dramatically. Commodity companies and businesses with pricing power can outperform in inflationary environments, according to investor experience since the 1970s. Knowing how inflation affects the value of your company can help you make better business decisions ranging from purchasing and pricing products/services to exit strategies and tax planning.
Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University and Wall Street's "Dean of Valuation," has written about what kind of businesses do better in an inflationary environment. Inspired by his work, here’s some of the key factors one should reflect on when assessing the impact of inflation on valuation.
- Pricing Power - the size of the total available market and market share affect pricing power. Obviously it’s not good if you can’t pass on price increases on to customers. Non-discretionary spending on products and services, that you can’t delayed or substitute will have greater pricing power.
- Competition - the more competitive the industry you operate in the less pricing power you’re going to have.
- Price regulation - businesses that face price regulation are at the mercy of governmental or regulatory authority pricing decisions.
- Cost structure - a businesses cost structure is important. A company with significant, inflation-sensitive costs will be vulnerable to high inflation. As in non inflationary times higher margins are better!
- Capital intensity - how much capital does your business need to grow? Inflation has a greater negative impact on companies with longer-term, more rigid investment options. For example manufacturing companies often need to invest large amounts of capital over longer time periods than service or technology companies.
- Flexibility on timing - companies with more flexibility and time to exit or postpone investments fare better in the face of inflationary storms than companies with less flexibility.
How Does Higher Inflation Influence Risk?
- Cost of Equity - the rate of return sought by equity investors is likely to rise. Inflation has a greater negative impact on high-risk companies. And businesses in riskier industries, which are more vulnerable to market/economic fluctuations, will see equity costs rise faster than companies in more stable industries. In other words a higher required rate of return is going to come though in the multiple a Private Equity firm might place on your business.
- Cost of debt - The cost of debt is the cost of borrowing money after deducting certain tax benefits. Higher inflation has a greater negative impact on businesses that are more vulnerable to default.
- Debt v quality of earnings - debt costs may rise less for companies with higher, more stable earnings than for companies with lower or negative earnings.
- Debt capacity impact on deal structure - some M&A deals will be able to carry less debt, and this will impact on deal pricing if the investors are required to put more equity into he transaction.
- Risk of failure - failure risk is the possibility of a catastrophic event putting your business at risk. Higher inflation has an unusually negative impact on companies with a higher failure risk like start-ups and early stage businesses with unproven business models
- It’s not all bad - of course a bit of inflation can reduce the real cost of repaying long term debt so it’s not all bad.
How Can You Combat the Effects of Inflation on the Value of Your Business?
So the impact of inflation on the value of your business depends on its impact on expected cash flow/growth and risk.
During periods of high inflation, companies with pricing power on their products and services, low cost of goods, overhead base, and short-term, flexible investments are going to do better.
Companies with large, stable earnings streams and less debt fare better in inflationary environments (actually all the time?) and have greater purchasing power as prices rise.
Here’s just a 3 ways you can mitigate the impact of inflation on your business and its value:
- Increase your prices – Are your products and services are under priced – this is time to challenge your pricing. If you do put up prices communicate any increases to your customers honestly by explaining the "why,"
- Strategies to leverage your fixed cost base - Improve net return by considering an expansion strategy perhaps adding new products and services to the mix to boost profit margins by leveraging fixed costs even more. Push your best-selling products in more places, both digitally and in real life. You ought to get a purchasing benefit too if greater scale allows you to renegotiate raw material pricing with suppliers.
- Examine your finances - Look at your debt and funding structure. Could you refinance or consolidate your debt to achieve a lower overall cost of funding?