At the moment inflation is on the mind of every businessman/woman on the planet. COVID-19 has had a very strange impact on the global economy.
While small businesses have been struggling due to government restrictions on the free movement of people at the same time a lot of „free“ money has been thrown in the market in the form of soft loans, subsidies and the purchase of securities by government with the aim of keeping interest rates down and stock prices up.
This has created a „zombie“ world where the global economy based on traditional indicators is booming while at the same time factories have to stop production a few days a week and push supply dates out due to a lack of materials caused by problems in global supply chains. Add to this the quick rise in the price of commodities, the pent up savings of people that did not travel and spend during the pandemic and you have the perfect environment for high inflation.
The economic definition of inflation is a general increase in prices and fall in the purchasing value of money. At first, this sounds like a simple concept, but actually it is quite complex. Inflation affects numerous aspects of the market and many factors influence it. If prices go up, the current value of the currency is eroded. From this vantage point, some may see inflation as a bad thing. However, the right balance of inflation and economic growth is important for a healthy economy.
In general, economies are expected to grow—not stay the same or slow down. A growing economy (possibly caused by low interest rates) can cause inflation, as consumers in these economies typically feel confident about the future and spend more money. Sellers anticipate this demand and raise prices, creating inflation. This is also known as “demand-pull” inflation. When supply is not keeping up with demand, prices can become even higher. If consumers expect further inflation in the future, they may make purchases sooner in order to avoid higher prices down the road, which in turn benefits economic growth.
In contrast, inflation can occur even without economic growth. An increase in the cost of business can cause inflation as well. If manufacturers slow output while demand remains the same, then prices will go up as a result of basic supply and demand principles. Manufacturers could slow down due to higher wages, new taxes or an increase in the cost of exports (foreign exchange or FX cost). This is known as “cost-push” inflation.
Money Supply Expansion
Expansion in the money supply is another major cause of inflation. This occurs when the government or central bank introduces additional money into the economy to spur spending and growth, but the level of production of goods and services remains constant. More money in the economy generally causes increased demand, and this demand chases the same amount of goods. Therefore, prices go up in order to avoid a shortage of supply. In this scenario, inflation erodes the value of money and purchasing power decreases.
The government can also add money into the economy through the purchase of bonds in the marketplace, which is commonly called quantitative easing (QE). The goal of QE is to inflate prices of bonds so that yields decline, consequently keeping rates low to spur easy lending and growth in the economy.
So how does the current rise in inflation affect the value of companies and mergers and acquisitions activity?
First and foremost the value of companies is driven by profits. The higher the profits the higher the valuation. This means that valuations in general are higher in a high growth environment. The problem is that we believe that the governments around the world have overdone it with money supply expansion because of COVID-19 and the demand for goods and services is artificial to a large extent. The second point is that the global supply chains are not running smooth due to restrictions and this is pushing up the prices of raw materials and semi-finished goods. The third point is that the quantitative easing is pushing up security prices and real estate prices around the world creating a lot of paper wealth. What you should ask yourself is how do the macroeconomic forces at play impact the profitability of your company in the next few years. Can you pass on the price increases in your raw materials to your customers? Will there be a drop in demand in your goods/services, when the government spending stops, security prices drop?
Second the value of companies is driven by the returns demanded by the investors. Currently the interest rates are very low and there are not many investment opportunities with attractive rates of return without significant risk. When interest rates go up so will the returns demanded by investors. The rate of inflation influences the direction of interest rates and, conversely, interest rates influence the direction of inflation. If inflation is high, interest rates will typically be raised by the central bank to slow economic growth. If inflation is low, economic growth is generally low, and a decrease in rates is enacted in order to lower the cost of borrowing and to spur economic growth.
The chart below shows that up to around 2015 in the EU there has been a steady relationship between interest rates and inflation.
From then the EU central bank was reluctant to increase the interest rate due to fears of a slower growth. The low rate was obviously kept low during the pandemic so that governments and companies could survive. Now inflation is exploding and sooner rather than later the interest rates will be raised bringing company valuations down.
Our thinking is that for anyone wishing to sell their business the time is now as there may not be such a favourable economic environment for at least the next 10 years.
Thirdly, the value of companies is driven by how investors see the future. At the moment despite the growth in financial markets around the world, which normally signals optimism and an increase in M&A deal volume this has not materialised and deal levels are around long-term average levels or lower. To us this means that investors are expecting a slow down as soon as the governments stop their quantitative easing and zero interest madness. Again, this is pointing towards hurrying up with selling your business, if you are thinking about it.
On the other hand, if your business has very steady cash flows, the industry you are in is growing and the inflation persists for a longer period you may still sell at an attractive valuation even, if you miss the boat in this environment. Some of the industries where we see a smaller interest impact on valuations are telecommunications, internet based companies, IT, environmental services, healthy food producers, etc. while some sectors like real estate , traditional retail, heavy capital expenditure industries could be affected significantly.
In any case hope for the best but prepare for the worst. Whatever happens we strongly believe that having experienced financial advisors at your side when thinking about selling your business and during the sales process is invaluable and we will be happy to speak to you about your plans in a meeting or over a tasty lunch.