Implications of a UK Stagflation on Business Valuation
Stagflation is a rare economic phenomenon that occurs when the economy experiences both stagnant growth and high inflation. This scenario poses significant challenges for businesses as they navigate through an environment of high cost, low demand and high interest rates. Here, we examine the impact of a UK stagflation in the context of the chancellor’s 2023 spring budget on business valuation over the medium term.
1. Higher Taxation
In a stagflation economy, governments often resort to raising taxes to combat inflation, reduce deficits and boost revenues. An increase in corporate tax can lead to lower after-tax profits which can negatively affect a company’s valuation. This is because valuations are often based on a company’s earnings, and higher taxes reduce the amount of earnings available to shareholders.
Example: A £6m revenue business with operating margin of 20%; (£1.2m), an annual growth rate of c. 5% and cost of capital of 10% could attract an intrinsic valuation of approximately £18m. Such entity could see up to £1m wiped off its valuation by the increase in corporation tax from 19% to 25%. Therefore, a significant increase in corporation tax could result in lower earnings and thus valuation.
2. High Inflation
High inflation often leads to higher input costs for businesses such as materials, labour and overhead costs. This can reduce a company’s profit margins and negatively impact its valuation as investors may be less inclined to pay a premium for a business with lower profitability. The longer high inflation persists, the lower the expected future performance of the business and ergo its valuation.
Assume same £6m revenue business. If inflation rises to the current level of 10% and it chooses to absorb the cost rather than raise prices, such business could see its payroll cost rise by 10% - 20% and its valuation decline by as much as £4m in a prolonged stagflation. Higher staff cost erodes future profitability and business valuation due to its compound effect.
3. High Interest Rates
In a stagflation economy, central banks often raise interest rates to combat inflation. Where labour market is tight and consumer confidence remain bullish, central banks may keep interest rates high for an extended period. Of course, when interest rates rise, the cost of debt increases, and as a result, the company’s weighted cost of capital (WACC) increases. WACC is the discount rate used to determine the intrinsic value of an entity and represents the minimum return debt and equity investors require for investing in the company. A higher WACC therefore reduces the present value of a company’s future cash flows as well as its enterprise value.
Assume same £6m revenue business again. If cost of capital (WACC) rise to say 15% from 10%, valuation could fall by as much as £5m if forced to raise capital while rates remain high.
4. Low Growth
Low growth is another feature of a stagflation economy. In such environment, businesses face lower demand for products and services, reducing their revenue and profitability. Additionally, low growth makes it difficult for businesses to expand, acquire new customers, and increase market share. This reduces their long term growth prospects, which also reduces their valuation.
Indeed higher taxation, high inflation, high interest rates and low growth have a significant impact on business valuation in a stagflationary economy. These factors reduce revenue and profitability, impact long term growth prospects and make businesses less attractive to potential buyers. If these conditions become non-transitory, and specific actions aren’t taken to address the risks, businesses could see up to half of their valuation lost to macro headwinds beyond their control.
Therefore, to mitigate these risks, businesses must adopt strategies that reduce cost, streamline operations, expand product and service offerings, diversify their customer base and invest in initiatives that yield higher return than that which providers of their capital require.
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