Valuation considerations during an increased inflationary environment

Put simply, the effects of inflation on a company’s value come down to how inflation impacts a company’s current and future cash flows. Three key levers drive this process:

Repricing

What is the ability of a company to reprice its goods or services? A company’s ability to reprice its goods is a function of the size of the total accessible market and its relative market share of that specific market. Companies that can pass on price increases to their customers are better protected from the effects of high inflation and are better able to maintain their operating margins. If increased costs cannot be passed on to customers through higher prices, this leads to a negative effect on operating margins and thus on the value of the company, ceteris paribus.

Cost structure

Cost structure is determined by a company’s relative repricing power and cost efficiencies. Companies that have substantial, inflation-sensitive costs are more exposed to the effects of higher inflation, with the opposite also being true. The question is what are companies doing about it, and have these mechanisms or scenarios been built into expected cashflows?

• How significant are current inflationary pressures? Price increases are a given in any inflationary environment, but companies that consistently address total customer and product profitability are likely to weather inflationary cycles better than those that focus solely on cost changes.
  
  
• Does management’s business plan allow for price adjustments based on customers’ willingness to pay, and on product differentiation within an acceptable range?
  
  
• Has management identified the products most affected by inflation with the aim of adjusting product sourcing or product design? In other words, addressing materials, packaging, or even product features, in response to elevated production and servicing costs, while maintaining the functionality customers require.

Growth Capital & Investment efficiency

This is a measure of how much investment is needed to grow. Companies with longer term, inflexible investment profiles are more likely to be negatively affected by inflation. For example, infrastructure and manufacturing businesses in general are required to invest significant amounts of capital for longer periods of time than do service or technology companies. Companies with the flexibility and time to pull out of, or delay, investments are better positioned to weather inflationary storms than companies with less flexibility.

The M&A environment is most comfortable with moderate, stable inflation. Historically, the highest valuation multiples are paid in such an environment because the reliability of earnings estimates is high and uncertainty is correspondingly low. Current high inflationary forces are likely to result in company valuations coming under pressure from an earnings perspective, leading to volatile and tightening valuation multiples. It is critical to assess and understand subject company cash flows in navigating such uncertainties, and to understand the company's true value in such an environment.

---

Photo: michaeljung - stock.adobe.com