The October issue of Business Valuation Update has some essential guidance for any business valuation expert in the form of “Valuation Considerations in High Inflationary Environments.” With UK predictions now in the 14%-to-20% range despite Liz Truss’ initial policies, no valuation completed in the next year will be unaffected by inflation.
The analysis, by William Harris, reviews US market returns. Among its findings are:
During high inflationary periods, the average P/E multiple for the S&P 500 index was 12.12, which is 44.45% lower than the multiple of 21.82 during low or normal inflationary periods. Furthermore, the average earnings per share for the index was noticeably lower. During high inflationary periods, the average earnings per share for the index was $58.52. This is 20% lower than the average earnings per share of $73.19 during normal inflationary periods.
Harris alerts financial experts to several factors to consider with respect to the lower multiples during high inflationary periods:
- Stock prices are a reflection of investor expectations of a company’s future earnings potential;
- During low or stable inflationary periods, there is a higher likelihood of economic growth as the Federal Reserve will not take measures, such as increasing interest rates, to slow economic activity;
- Lower interest rates and stable inflation rates promote continued economic activity, and, as a result, investors are willing to pay a higher price for every dollar of a company’s earnings; and
- In low and stable inflationary environments, companies typically achieve higher rates of real growth attributable to underlying market demand.
“Furthermore, investors’ rate of return expectations are lower as the stable economic conditions reduce the level of risk associated with their investments,” Harris says. The article offers a number of ways business valuers can account for this difference in this extraordinary period of inflation forecasts.