The U.S. annual inflation rate jumped to 8.5% in March 2022, the largest increase since December 1981. This was caused by global supply chain bottlenecks, high consumer demand, and the war in Ukraine. Sectors impacted include:
Energy prices surged 32% (including gasoline’s increase of 48%)
Food prices increased 8.8%
New vehicles jumped 12.5%
When considering inflation’s influence on business valuations, there are several variables impacted. Here’s a quick review of the impact of inflation on different valuation approaches:
Asset approach
This approach is used when financial results are consistently poor, or a real estate company/holding company is being valued.
As current market values are used to value assets, high inflation causes higher market (replacement) values, and therefore a higher business valuation amount.
Market approach
This uses past sales data of comparable companies (“comps”) and applies an average price multiple to the subject company to compute a valuation amount.
This approach may over-inflate a business valuation as it mainly includes data from the past 5 years (which is prior to the onset of high inflation).
Income approach
This is used when the subject company’s cash flows can be reasonably forecasted.
In this approach, substantial inflation increases the discount rate, the cost of goods sold, and operating expenses – each impact lowers the business valuation amount. Also, although the subject company may increase its sales prices to offset these losses, rarely can prices be raised to a point to completely offset all losses.
In summary, when high inflation is factored into a business valuation, the valuation amount is generally lower. Finally, who can benefit from a lower business value?
Gift and estate tax transfers - more shares can be transferred.
Divorce - for the party wanting to show a lesser value.
Buyer of a business - wants to buy a business at a lesser amount.
