The most common questions we receive from prospective clients are usually some form of “How much would my company sell for?” or “Are valuations likely to go up or down in the near term?” While many factors affect the prices buyers are willing to pay, a key element is changing market interest rates. In general, when interest rates go up, valuations go down; when rates go down, valuations go up; and when rates are stable, valuations are not impacted. Here’s why:
In our November 8, 2022, edition of Deal Notes™, we discussed the reasons why a Discounted Cash Flow (DCF) analysis is the most accurate and reliable means of valuing a company. A key step in a DCF analysis is determining the proper Weighted Average Cost of Capital (WACC) to use in discounting projected future cash flows, to arrive at the Enterprise Value (EV) of the company. While the WACC calculation accounts for a number of market, industry, and company risk factors, one objective element is the “risk-free” rate. When the Federal Reserve (Fed) raises interest rates, the “risk-free” component of the WACC increases, resulting in a higher WACC. With an increased WACC discount rate, the DCF analysis calculates to a lower EV. Thus, in an economic environment where the Fed is expected to continue raising interest rates, EVs can be expected to fall, all other factors being equal.
Rising interest rates can depress valuations for another reason: since higher interest rates typically result in tightening economic conditions, they can cause buyers of companies to question the integrity of projections offered by sellers. If sellers are unable to explain how their projections account for the expected deterioration of general market activity, buyers will reduce those projections as they perform their own DCF calculations in arriving at their bid prices.
Rates have been rising for 18 months now and we have seen a corresponding decline in M&A activity as a result. Given that most economists are expecting interest rates to stabilize in the months ahead, we expect M&A activity to pick up in the balance of 2023, as buyers and sellers become comfortable assuming that future changes in interest rates will have a small impact on valuations.
Have a great day, everyone.
Managing Director, Aerospace