How Does the Economy Impact the Value of a Business?
You’re on course to sell your business. You’ve created an exit plan and a marketing strategy when you see headlines about shifting economic winds. You think, “My business is in good shape. There’s no need for concern.”
Don’t count on it. The value of a business, even one that is well-managed, can rise or fall with conditions in the broader economy. And while some of the economic impact on business valuation can be managed, other aspects are outside the business owner’s control.
What Really Determines Business Valuations?
Profits are the single most important factor in business valuations. Regardless of the valuation model used—be it an income approach or a market approach—the higher the profits, the higher the price buyers are willing to pay.
More than the profit a business has generated in the past, buyers want to know how much profit the company is likely to make in the future. When the economy is strong, buyers will rely on a company’s past performance as an indicator of its future direction. But a struggling economy casts doubt over the future, no matter the strength of a company’s past balance sheet.
An uncertain future means more risk for buyers. They will adjust valuations to account for risk, usually by lowering the price they’re willing to pay for an acquisition.
Here’s how it works:
The Economy’s Impact on Income Valuations
When businesses are valued using an income approach, buyers look at the company’s historical and future earnings or cash flow to arrive at a present value for the business. The capitalization of earnings method divides a company's historical cash flow by its capitalization rate. The capitalization rate, expressed as a percentage, includes returns on capital and debt. By using this method, one can evaluate potential risks and determine the possible return on investment.
Another way buyers might lower their valuation for the perceived risk in an acquisition is by applying a discount rate. A discount rate is an amount, such as 10%, that represents the return an investor would receive on a different investment, like the stock market, or if the same dollars were to sit in a bank earning interest.
Using a discounted cash flow (DCF) analysis, a valuation expert or CPA would calculate the total cash flow of a business over a given period of time, and then discount the value by the discount rate amount.
How the Economy Affects a Market Approach to Valuations
A market valuation looks at the sale price of similar businesses to arrive at a valuation for an individual business. Business appraisers and valuation experts compare not only sale prices, but they also compare a company’s profit margins to the metrics of similar businesses that have sold. They then apply a multiple—a number like “two” or “three”—to the present value to calculate the value of the business.
The multiple used varies by industry, and multiples can change depending on economic conditions. Economic factors like inflation, interest rates, and unemployment will drive a multiple up or down.
Let’s take the example of a restaurant business where the industry’s average multiple is two times earnings. When the economy is booming and consumers have a lot of money to spend on discretionary purchases, the buyer of a restaurant business might apply a multiple of 2.5 because there’s much optimism about the future growth potential of the restaurant. Using this multiple, the valuation of a restaurant with earnings of $100,000 would be $250,000 (2.5 x $100,000).
But what happens in an inflationary period or one with high unemployment? That same buyer will say, “We can’t know if this restaurant’s future earnings will look anything like its historical earnings because consumers just aren’t spending, and when they do, they spend much less than they did when the economy was strong.”
To compensate for the uncertain future, a buyer might insist on a multiple of 1.5, bringing the valuation of that same restaurant down to $150,000, even though there’s been no change in the restaurant’s income.
The expression, “A rising tide raises all ships” is as true for business valuations as it is for nautical endeavors. When the economy is strong, all businesses benefit, and market values increase across the board. But a weak economy lowers the price buyers are willing to pay, regardless of the strengths of an individual business.
Economic Factors That Pose Increased Risk
The three economic factors that have the biggest impact on valuations are:
- Inflation
- Interest rates
- Unemployment
The three tend to be interconnected. High inflation will drive up interest rates and unemployment, and low inflation will do the opposite.
Economic factors have a very real impact on both business growth rates and the way buyers view mergers and acquisitions. They might demand more profit or cash flow just because the future is uncertain.
Inflation and the Bottom Line
Inflation, whether caused by a supply/demand imbalance, supply chain disruptions, political unrest, or any other reason, increases the price of goods and services and the cost of doing business. In an inflationary environment, rents rise, utility and fuel costs increase, and workers demand higher wages to keep up.
Some businesses sell essential goods and services and can pass price increases along to their customers. These types of companies might see little impact from inflation and their fair market value might remain stable despite the inflationary environment.
But businesses that sell non-essential goods and services might be unable to raise prices. During inflationary periods, customers reduce spending or stop buying altogether, and these businesses may see their margins cut because they must absorb the price increases.
Low inflation keeps costs low, encourages more spending, and keeps profit margins high. High inflation reduces demand for products and services, slows business growth, and lowers profit margins, making businesses worth less to investors.
The Effect of Interest Rates on Business Valuations
As a business owner, you’ve probably heard the term “cheap money.” It’s a phrase that means economic conditions where interest rates—the cost to borrow money—are low.
Low interest rates encourage investors and business owners to take on debt for business and real estate acquisitions, for expansion, and to make improvements to their operations, contributing to the growth of the U.S. economy. Occasionally however, the economy can become overheated. Demand outstrips supply, inflation threatens economic stability, and the Federal Reserve steps in to restore the balance.
When the Fed raises its benchmark interest rate, capital markets follow suit. More expensive debt makes buying a business more expensive and lowers the returns a buyer gets, so they’re likely to reduce the amount they’re willing to pay for a business.
The Good and the Bad of Employment Rates
Common wisdom is that low unemployment rates are good for business—and therefore business valuations—but that’s not always the case.
It’s true that when more people work, they pump more money into the economy, and businesses make more profit, one of the chief factors affecting business valuations. But persistently low unemployment rates also create labor shortages. Employers must pay more to attract workers. Higher wages can negatively impact profit margins, and with it, business valuations.
On the other side, high unemployment keeps wages from rising. The competition for fewer jobs than there are workers to fill them allows employers to keep a tight cap on wages and funnel more of their revenues into profits—more good news for business valuations.
High unemployment can be good news for valuations in other ways too. Periods of high unemployment have historically driven more workers to start their own businesses. An increasing pool of buyers creates competition that can drive up business valuations. This is especially true for small businesses. They attract the largest share of new business owners during economic downturns.
The last point is that high unemployment typically drives inflation and lowers interest rates, moderating the factors contributing to lower profit margins.
What Can Business Owners Do to Keep Valuations From Eroding?
As a small business owner, you obviously can’t control what happens in the larger economy, but it’s possible to mitigate the effects of inflation and other economic impacts on your business valuation. Some of the ways to adjust for economic conditions include:
- Cut costs. Take a hard look at your expenses. Cutting expenses wherever possible will help to keep profit margins from deteriorating.
- Adjust marketing strategies. Redeploy marketing dollars to initiatives that directly drive sales and reduce or eliminate initiatives that focus on branding, such as sponsorships. Make sure your messaging clearly articulates the benefits to the customer.
- Increase cash flow. Refine your product and service offerings to align with consumer demand. It’s much more difficult to get new customers than to increase business from existing customers. Even if you must lower prices, you’ll have a shot at maintaining your profitability if you can keep your customers buying from you.
- Think long term. Don’t wait for an economic downturn to plan for it. Economies are cyclical, and your business plan should address strategies for the bad times as well as the good. Don’t think short term. Knee-jerk reactions like cutting your workforce often backfire. By having a long-term strategy for growth, you’ll be better positioned to weather economic downturns.
To learn more about trends in the business for sale marketplace, read BizBuySell’s quarterly Insight Report. This nationally recognized economic indicator tracks the health of the U.S. small business economy. By analyzing sales and listing prices for small businesses across the country, this report provides valuable economic indicators for small business transactions. Armed with the latest economic data, you’ll be able to determine the right time to buy or sell a business.