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Inflation and its Effect on Company Valuations

Gabor Szendroi, Managing Partner at Concorde MB Partners – IMAP Hungary looks at the effect inflation has on company valuations, and what company owners looking to sell should expect

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-RƥEXMSRERHMXW)JJIGX
on Company Valuations
/ BUSINESS FOCUS
INFLATION AFFECTING COMPANY VALUATIONS
In Creating Value, we always try to dissect the
current issues affecting corporate transactions.
Undoubtably, the most interesting development
SZIVXLITEWXQSRXLWMWXLIVIZMZEPSJMRƥEXMSR
which almost completely disappeared more
than 10 years ago but is now virtually a global
phenomenon, to a greater or lesser extent.
+ɧFSV7^IRHVˉM1EREKMRK4EVXRIVEX'SRGSVHI
MB Partners – IMAP Hungary looks at what
XLMWQIERWJSV1 %XLIIJJIGXMRƥEXMSRLEWSR
company valuations, and what company owners
RS[PSSOMRKXSWIPPWLSYPHITIGX#
+Ɍ367)2(6ˈ-
Managing Partner
Concorde MB Partners – IMAP Hungary
gabor.szendroi@imap.com
However, the world changed in 2022. A huge wave
of inflation began across the world which, for the
time being at least, is still to peak in many places. So,
the question arises: How does this affect company
ZEPYEXMSRW#;I[MPPITPSVIXLIMWWYIJVSQJSYV
different perspectives; the effect of current uncertainty
on valuations; the cost of capital in an inflationary
environment; the difference between cost and income
inflationary pressure; and finally, accounting and
XEEXMSRMWWYIW-RSYVƤRHMRKW[IXEOIMRXSEGGSYRX
hypotheses from the university thesis of our former
colleague, Dr. Márk Radó, written in the late 1990s as
well as his PHD thesis written in the late 2000s, and
give thanks for his collaboration.
BUSINESS FOCUS /2
INFLATION AFFECTING COMPANY VALUATIONS
Ʉ
-
n recent years, businesses were operating in
an environment in which inflation wasn’t even a
consideration in strategic or operational decision-
making. The abundance of cheap money and the
shortage of qualified labour caused an astonishing
rise in prices in several sub-markets (various raw
materials and asset classes such as real estate
and some stock groups showed significant price
inflation), however, consumer price levels in general
remained almost stationary. As a result, interest rates
fell to unprecedented depths (just look at the negative
base interest rates appearing in several countries).
However, while there were many challenges and much
uncertainty, the general rise in prices could for the
most part, be ignored.
3/ BUSINESS FOCUS
INFLATION AFFECTING COMPANY VALUATIONS
The Issue of Uncertainty
-RXSHE]ŭWIRZMVSRQIRXFSXLMRƥEXMSRERHXLILYKI
fluctuation of foreign exchange rates are causing
enormous uncertainty. Other international events
taking place around us, including the Ukrainian war
in Europe, create yet further uncertainty. In such
an environment, investors are more hesitant as
their relative expected returns increase which
has a negative effect on the value of real assets,
including company value. In order for relative return
expectations to decrease, we would need a return
to the 4-5 years of economic stability that we had
prior to the COVID pandemic. It’s important to note
however, that market uncertainty can damage
GSQTER]ZEPYEXMSRWVIKEVHPIWWSJMRƥEXMSRWSIZIR
a recessionary environment and resulting fall in
inflation won’t necessarily result in a decrease in
relative return expectations - this would require the
remaining causes of uncertainty, such as the Ukraine
war, to disappear.
'SWXSJ'ETMXEPMRER-RƥEXMSREV])RZMVSRQIRX
Risk-free interest rates, which have increased as a
result of inflationary pressure, also move nominal
return expectations significantly upwards, which
once again sparks a decline in company valuations.
Therefore, in order for company valuations to increase
again, risk-free interest rates must start to decrease.
-RƥEXMSREV]4VIWWYVISRXLI'SQTER]'SWX7XVYGXYVI
and Income
In an inflationary environment, the relative valuation
of some companies may also change. If the effect of
MRƥEXMSREJJIGXWXLIGSWXWXVYGXYVISJEGSQTER]FYXXLI
company is unable to offset this increase in costs on the
sales side with price and sales volume increases, then its
EFMPMX]XSKIRIVEXITVSƤXQE]HIGVIEWI[LMGLEPWSPIEHW
to a decrease in the company’s value. This situation
will continue until the company regains its previous
RSQMREPTVSƤXEFMPMX]3JGSYVWIXLMWMWEPWSHITIRHIRX
on the company’s market position and its negotiation
power vis-à-vis its suppliers and buyers as there are
GSQTERMIW[LSGERVEMWIXLIMVQEVKMRWMRERMRƥEXMSREV]
IRZMVSRQIRXVIWYPXMRKMRMRGVIEWMRKTVSƤXEFMPMX]
BUSINESS FOCUS /4
INFLATION AFFECTING COMPANY VALUATIONS
Accounting and Taxation Issues
Company valuations also change in an inflationary
environment due to certain accounting and related-
XEEXMSRMWWYIWWYGLEWXLIJVIIGEWLƥS[EZEMPEFPIXS
the owners and schedule may change depending on
the below factors:
• Fixed assets which are recorded at the purchase
price and written off accordingly. With a jump in
MRƥEXMSRXLIFEWMWSJHITVIGMEXMSRJEPPWWLSVXSJXLI
asset’s replacement value. Therefore, the amount
of depreciation tax shield (due to accounting for
depreciation that does not involve cash flow, the
amount of tax to be paid is reduced) decreases.
8LYWXLIGSQTER]GVIEXIWERETTEVIRXMRƥEXMSREV]
TVSƤX[LMGLMWXEIH
• As a result of the company’s decision regarding their
inventory valuation method, the inventory on the
balance sheet or the inventory usage accounted for
as a cost, or both, differ from what is economically
justified (especially in the case of slow-moving
inventory where it is true that the cost displayed at the
time of use/sale falls short of the asset replacement
value). If the use of inventory accounted for as a cost
in the profit and loss statement falls short of this
PIZIPERETTEVIRXMRƥEXMSREV]TVSƤXMWGVIEXIH[LMGL
is again taxed. In a similar scenario, inventories
recorded at a lower level in the balance sheet may
underestimate the company’s current real working
capital needs
• %WMRƥEXMSRMRGVIEWIWXLIVIEPZEPYISJXLIGETMXEPSJ
the borrowed loan decreases, while the weight of the
interest paid increases in the income statement. As a
result, the tax shield from interest increases, which it
WLSYPHFIRSXIHLEWETSWMXMZIIJJIGXSRGEWLƥS[W
• Regardless of the method chosen for inventory
valuation, companies have to continuously spend
JYRHWXSMRGVIEWIRIX[SVOMRKGETMXEPMRERMRƥEXMSREV]
environment. The increase in raw materials, semi-
finished and finished products, and receivables
resulting from inflation is only partially offset by
WYTTPMIVŭWWXSGOKVS[XLXLIVIJSVIIZIREWMKRMƤGERX
part of the cash generated during operations is tied
up in working capital
As we have seen, inflation has a negative impact
on company valuations in at least the four different
ways described. While it is impossible to determine
the relative impact of these on a company’s value, the
VIWYPXMRKIJJIGXMWQSWXHIƤRMXIP]RIKEXMZI8LIVIJSVI
it is no coincidence that the best proxies of company
valuations in general, the stock exchange indices,
decreased by 10-25% in 2022; i.e., the valuations of
the largest companies listed on the stock exchange
decreased by this much in each country and
unfortunately, the end of this devaluation process is
still not in sight.
Taking all of these factors into account, it is safe to say
that, compared to a year ago, private companies have
also depreciated by 10-25% as a result of uncertainty
and inflation. It is therefore, little wonder that the
number of transactions decreased in 2022 as it takes
time for prospective company sellers to adjust to
the new reality. As valuation expectations begin to
adjust, we expect to see the number of transactions to
increase again.
Unfortunately, the end of the devaluation process
is still not in sight

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Inflation and its Effect on Company Valuations

  • 1. -RƥEXMSRERHMXW)JJIGX on Company Valuations / BUSINESS FOCUS INFLATION AFFECTING COMPANY VALUATIONS In Creating Value, we always try to dissect the current issues affecting corporate transactions. Undoubtably, the most interesting development SZIVXLITEWXQSRXLWMWXLIVIZMZEPSJMRƥEXMSR which almost completely disappeared more than 10 years ago but is now virtually a global phenomenon, to a greater or lesser extent. +ɧFSV7^IRHVˉM1EREKMRK4EVXRIVEX'SRGSVHI MB Partners – IMAP Hungary looks at what XLMWQIERWJSV1 %XLIIJJIGXMRƥEXMSRLEWSR company valuations, and what company owners RS[PSSOMRKXSWIPPWLSYPHITIGX# +Ɍ367)2(6ˈ- Managing Partner Concorde MB Partners – IMAP Hungary gabor.szendroi@imap.com
  • 2. However, the world changed in 2022. A huge wave of inflation began across the world which, for the time being at least, is still to peak in many places. So, the question arises: How does this affect company ZEPYEXMSRW#;I[MPPITPSVIXLIMWWYIJVSQJSYV different perspectives; the effect of current uncertainty on valuations; the cost of capital in an inflationary environment; the difference between cost and income inflationary pressure; and finally, accounting and XEEXMSRMWWYIW-RSYVƤRHMRKW[IXEOIMRXSEGGSYRX hypotheses from the university thesis of our former colleague, Dr. Márk Radó, written in the late 1990s as well as his PHD thesis written in the late 2000s, and give thanks for his collaboration. BUSINESS FOCUS /2 INFLATION AFFECTING COMPANY VALUATIONS Ʉ - n recent years, businesses were operating in an environment in which inflation wasn’t even a consideration in strategic or operational decision- making. The abundance of cheap money and the shortage of qualified labour caused an astonishing rise in prices in several sub-markets (various raw materials and asset classes such as real estate and some stock groups showed significant price inflation), however, consumer price levels in general remained almost stationary. As a result, interest rates fell to unprecedented depths (just look at the negative base interest rates appearing in several countries). However, while there were many challenges and much uncertainty, the general rise in prices could for the most part, be ignored.
  • 3. 3/ BUSINESS FOCUS INFLATION AFFECTING COMPANY VALUATIONS The Issue of Uncertainty -RXSHE]ŭWIRZMVSRQIRXFSXLMRƥEXMSRERHXLILYKI fluctuation of foreign exchange rates are causing enormous uncertainty. Other international events taking place around us, including the Ukrainian war in Europe, create yet further uncertainty. In such an environment, investors are more hesitant as their relative expected returns increase which has a negative effect on the value of real assets, including company value. In order for relative return expectations to decrease, we would need a return to the 4-5 years of economic stability that we had prior to the COVID pandemic. It’s important to note however, that market uncertainty can damage GSQTER]ZEPYEXMSRWVIKEVHPIWWSJMRƥEXMSRWSIZIR a recessionary environment and resulting fall in inflation won’t necessarily result in a decrease in relative return expectations - this would require the remaining causes of uncertainty, such as the Ukraine war, to disappear. 'SWXSJ'ETMXEPMRER-RƥEXMSREV])RZMVSRQIRX Risk-free interest rates, which have increased as a result of inflationary pressure, also move nominal return expectations significantly upwards, which once again sparks a decline in company valuations. Therefore, in order for company valuations to increase again, risk-free interest rates must start to decrease. -RƥEXMSREV]4VIWWYVISRXLI'SQTER]'SWX7XVYGXYVI and Income In an inflationary environment, the relative valuation of some companies may also change. If the effect of MRƥEXMSREJJIGXWXLIGSWXWXVYGXYVISJEGSQTER]FYXXLI company is unable to offset this increase in costs on the sales side with price and sales volume increases, then its EFMPMX]XSKIRIVEXITVSƤXQE]HIGVIEWI[LMGLEPWSPIEHW to a decrease in the company’s value. This situation will continue until the company regains its previous RSQMREPTVSƤXEFMPMX]3JGSYVWIXLMWMWEPWSHITIRHIRX on the company’s market position and its negotiation power vis-à-vis its suppliers and buyers as there are GSQTERMIW[LSGERVEMWIXLIMVQEVKMRWMRERMRƥEXMSREV] IRZMVSRQIRXVIWYPXMRKMRMRGVIEWMRKTVSƤXEFMPMX]
  • 4. BUSINESS FOCUS /4 INFLATION AFFECTING COMPANY VALUATIONS Accounting and Taxation Issues Company valuations also change in an inflationary environment due to certain accounting and related- XEEXMSRMWWYIWWYGLEWXLIJVIIGEWLƥS[EZEMPEFPIXS the owners and schedule may change depending on the below factors: • Fixed assets which are recorded at the purchase price and written off accordingly. With a jump in MRƥEXMSRXLIFEWMWSJHITVIGMEXMSRJEPPWWLSVXSJXLI asset’s replacement value. Therefore, the amount of depreciation tax shield (due to accounting for depreciation that does not involve cash flow, the amount of tax to be paid is reduced) decreases. 8LYWXLIGSQTER]GVIEXIWERETTEVIRXMRƥEXMSREV] TVSƤX[LMGLMWXEIH • As a result of the company’s decision regarding their inventory valuation method, the inventory on the balance sheet or the inventory usage accounted for as a cost, or both, differ from what is economically justified (especially in the case of slow-moving inventory where it is true that the cost displayed at the time of use/sale falls short of the asset replacement value). If the use of inventory accounted for as a cost in the profit and loss statement falls short of this PIZIPERETTEVIRXMRƥEXMSREV]TVSƤXMWGVIEXIH[LMGL is again taxed. In a similar scenario, inventories recorded at a lower level in the balance sheet may underestimate the company’s current real working capital needs • %WMRƥEXMSRMRGVIEWIWXLIVIEPZEPYISJXLIGETMXEPSJ the borrowed loan decreases, while the weight of the interest paid increases in the income statement. As a result, the tax shield from interest increases, which it WLSYPHFIRSXIHLEWETSWMXMZIIJJIGXSRGEWLƥS[W • Regardless of the method chosen for inventory valuation, companies have to continuously spend JYRHWXSMRGVIEWIRIX[SVOMRKGETMXEPMRERMRƥEXMSREV] environment. The increase in raw materials, semi- finished and finished products, and receivables resulting from inflation is only partially offset by WYTTPMIVŭWWXSGOKVS[XLXLIVIJSVIIZIREWMKRMƤGERX part of the cash generated during operations is tied up in working capital As we have seen, inflation has a negative impact on company valuations in at least the four different ways described. While it is impossible to determine the relative impact of these on a company’s value, the VIWYPXMRKIJJIGXMWQSWXHIƤRMXIP]RIKEXMZI8LIVIJSVI it is no coincidence that the best proxies of company valuations in general, the stock exchange indices, decreased by 10-25% in 2022; i.e., the valuations of the largest companies listed on the stock exchange decreased by this much in each country and unfortunately, the end of this devaluation process is still not in sight. Taking all of these factors into account, it is safe to say that, compared to a year ago, private companies have also depreciated by 10-25% as a result of uncertainty and inflation. It is therefore, little wonder that the number of transactions decreased in 2022 as it takes time for prospective company sellers to adjust to the new reality. As valuation expectations begin to adjust, we expect to see the number of transactions to increase again. Unfortunately, the end of the devaluation process is still not in sight