Rising Prices and Inflation

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TAKEAWAYS

• With inflation and interest rates on the rise, companies will need to respond to the associated risks, and adjust their risk assessments.
• One of the major considerations are the risks associated with financial reporting, particularly relating to the fair value measurement.
• Businesses can do more to boost their resilience against the financial risks brought on by inflation.

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The onslaught of inflation has been a global phenomenon after the lingering COVID-19 pandemic, fuelled by increasing prices for natural gas and electricity due to the Russia-Ukraine war, supply chain disruptions and tightening financial conditions in most countries. According to the Eurostat statistics published in October 2022, the reported annual inflation in the European Union reached 10.9% in September 2022, while the United States recorded an 8.2% inflation rate in September 2022.

The International Monetary Fund’s ‘World Economic Outlook Update’, published in October 2022, showed an uptick in the headline inflation as well as in the underlying inflation. Global economic activity has also begun experiencing a broad-based and sharper-than-expected slowdown, with inflation higher than seen in several decades. Global growth is forecast to slow from 6% in 2021 to 3.2% in 2022, and 2.7% in 2023. This is the weakest growth profile since 2001, except for the global financial crisis and the acute phase of the COVID-19 pandemic.

IMPACT OF INFLATION ON VARIOUS ASSET CLASSES

The impact on prices of asset classes on account of inflation is mainly due to the difference in actual inflation versus expected inflation. While expected inflation is always priced in the asset’s value, the repricing happens to account for the actual inflation, as illustrated in Figure 1, according to Professor Aswath Damodaran, Professor of Finance, Stern School of Business, New York University.

Figure 1

Based on the historical data, with inflation at its peak and interest rates on the rise, it is reasonably expected that the energy, healthcare and financial sector may continue to perform well, while the consumer discretionary, utilities and materials sector may suffer. Companies will need to respond to, and manage, these risks which could lead to changes in risk assessment, business plans and even longer-term strategy. Now, one of the major considerations for companies are the risks associated with financial reporting, particularly relating to fair value measurement. The reasonableness and appropriateness of the estimates and inputs plugged into the fair value measurement process which need to factor in the inflation will be crucial.

To understand these risks better, below is an example of how rising interest rates and inflation will have an impact on financial reporting and operational decisions. In connection with goodwill impairment testing, let us divide inputs into two categories:

1) Internal inputs

• Revenue
• Costs of production/Cost of sales and other operating expenses

2) Market inputs

• Discount rate: Risk-free rate, cost of equity and cost of debt
• Currency volatility in case of cross-border operations

Figure 2

*Till 30 September 2022
Source: World Bank, S&P Capital IQ

Typically, the risk-free rate forms the basis of discount rate in the Discounted Cash Flow (DCF) method under the income approach for valuation. Therefore, an increase in the interest rate (shown in Figure 2), would usually lead to an increase in the overall discount rate. Additionally, in terms of cross-border operations, the associated risks are largely characterised as financial, economic, and political risks.

Under the financial risk, currency risk is the risk that exchange rates (the value of one currency versus another) will change unexpectedly. Under the normal circumstances, the currency of the projections should always be consistent with the currency of the discount rate. This implies that the inputs used to derive a discount rate (the denominator) should be in the same currency used to project cash flows (the numerator). There are two basic methods to address foreign currency cash flows in the valuation, assuming the analysis is being conducted in nominal terms, as illustrated in Figure 3.

Figure 3

Furthermore, due to rising inflation, the revenue growth rate may be reduced as a result of lower demand. At the same time, the increasing cost of production and other operating expenses would cause the margins to contract if they cannot be passed on to the customers. This, in turn, will decrease the overall value under the DCF method while testing for goodwill impairment. It will impact the headroom between the carrying amount and the fair value of the cash generating units if the decrease in fair value is not offset by improved cash flow assumptions. There are also various risks to consider, such as businesses’ ability to leverage and repay loans in a timely manner, credit-rating impacts and increasing cost of capital.

WILL INFLATION DECREASE BUSINESS VALUE AND TRIGGER IMPAIRMENT OF ASSETS?

Amid a flurry of geopolitical concerns, the most prominent risk for C-suite personnel, particularly the Chief Financial Officer (CFO), is to determine the possible impact on business and impending risk of impairment of assets.

IAS 36 Impairment of Assets requires a company to assess at each reporting date whether there is any indication of impairment (or an indication that a previously recognised impairment loss has reversed).

Sustained inflation could be an indicator of impairment for a company that is negatively affected by the high inflation rate. A likely candidate for such damage would be a company in the consumer discretionary space, whereby consumer demand is severely impacted due to the lower purchasing power and the elasticity of demand for discretionary products or services. The likelihood for an impairment testing increases significantly for such companies.

According to Prof Damodaran, it has been demonstrated that inflation affects a company’s value in the following ways:

• Companies that can pass their inflationary costs to customers in the form of price increases fare better during times of high inflation. The company’s pricing prowess is determined by the industry in which it operates.
• Companies whose cost structure comprises inflation-sensitive costs are likely to be affected negatively by inflation.
• Companies that have the ability to postpone their investment decisions in periods of high inflation will generally fare better. Such an option is generally not available to companies operating in the manufacturing or infrastructure sector where long-term investment is necessary.
• A general increase in the cost of equity may be observed across the board on account of the risk-free rate due to higher treasury bond yields. Sector-specific risk exacerbates the situation for companies that operate in inflation-sensitive sectors.
• The relationship between inflation and interest costs is positively correlated. Higher inflation leads to higher cost of debt. A heavily levered company will likely be a victim of inflation due to this correlation. Also, the cost of debt will be severely affected for a company with volatile earnings vis-à-vis a company with an established history of stable earnings.

WHAT CAN BUSINESSES DO TO MINIMISE THE IMPACT OF INFLATION?

• Increase prices: One of the reasons for price increases is supply chain disruptions. Companies would take cognisance of this disruption, and may take the opportunity to raise prices. Business owners could assess the ability of their customers to absorb the price hikes.
• Optimise operations: Business operations can be optimised by applying strategies, such as introducing high-margin products which help to leverage the fixed costs or bulk purchase from vendors in exchange for a discount. 

HOW DOES A VALUER CAPTURE THE IMPACT OF INFLATION IN BUSINESS VALUATION?

• Discount rate: The first order effect of inflation is increasing interest rates. A general increase in discount rates is expected as the majority of inputs, such as risk-free rate, and equity risk premium would be higher. A detailed assessment is warranted around the company-specific risk premium. A company sensitive to inflation warrants a higher alpha factor vis-à-vis an inflation-agnostic company. In particular, a higher discount rate may be applied to the growth companies for their future cash flows as compared with stable cash flows from the mature companies.
• Long-term growth rate: Often, the starting point for a long-term growth rate assumption in estimating the terminal value of the company is the risk-free rate. A practical challenge that is faced in this assumption is that recently, the risk-free rate has increased substantially, leading to overstated perpetuity values. The question that needs to be answered is whether such higher growth rate would be sustainable at the end of the discrete projection period. At times, a significantly higher growth rate may be indicative of a country facing hyperinflation with no real growth happening. At such times, valuers should assess the reasonableness of the input and consider alternative assumptions. For example, rather than relying on the most recent market inputs, a historical average rate which normalises the aberrations could be considered for the long-term growth rate.

In a nutshell, the effect of inflation on the value of assets or businesses is dependent on the impact it has on the expected cash flows, growth rate and risk associated with the assets or businesses. In the event that the inflation stays elevated for an extended period, the impact to the valuation will be increasingly significant, and the assumptions or inputs used in the valuation process will have to be critically assessed to derive the appropriate valuation conclusion for the purpose of financial reporting or transactions, such as mergers and acquisitions.

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Jason Pang is Associate Partner, Valuation Services, KNAV. Snehal Pawar and Kinjal Shah are Senior Manager and Manager respectively, Valuation Services, KNAV.