The increase in interest rates over the past year is wreaking havoc on business valuations and the ability to get deals done. So, if you are a potential seller of a business over the next few years, it is more important than ever to take the steps necessary to optimize enterprise value. Failure to do so will likely result in a very disappointing outcome.
The biggest way that rising interest rates impact company valuations is through their effect on discounted cash flow models. These models are a popular valuation tool used by investors to determine the intrinsic value of a business. They use a company’s projected cash flows and discounts back to present value, using a discount rate to account for the time value of money. As interest rates increase, the discount rate used in these models also increases, leading to lower present values and reduced company valuations.
Another big factor is the impact of rising interest rates on the cost of capital for companies. The cost of capital is the required rate of return that lenders and investors demand in exchange for providing capital to fund a transaction. As interest rates increase, the cost of capital also increases, making it more expensive for companies to raise capital through equity and debt financing. This makes it more difficult for an acquirer to hit their target return on investment which, ultimately, leads to a lower valuation and offer for the business.
Finally, another and more indirect way that rising interest rates impact company valuations is through their effect on consumer sentiment. As interest rates rise, consumers may have less disposable income to spend, leading to lower demand for goods and services. This can impact the outlook for revenues and profits, leading to lower valuations.
In light of the potential impact of rising interest rates on company valuations, businesses that plan to sell in the next few years need to focus on getting ready now. This means taking the obvious steps to improve financial performance, strengthen their balance sheet, and reduce their reliance on external financing. However, it really goes beyond make sure the financial house is in order. These businesses should explore ways to strengthen their value proposition, diversify revenue streams and reduce reliance on key personnel, clients and suppliers. These are all factors that can either enhance or kill value in a business.
In summary, rising interest rates can have a significant impact on company valuations, leading to shrinking valuations and reduced investor interest. It is more important than ever to make sure your business is positioned to command an EBITDA multiple on the high end of the range, rather than the low end.
To gain insight into where your company scores and compares on the eight key factors that impact the value of a business, click here.