Has the impact of inflation on UK business valuations officially ended?

BVWire–UKIssue #48-1
March 7, 2023

global business valuation

The Bank of England established their target inflation rate of 2% to help businesses and consumers plan. However, Nick Forrest (UK Economics Leader for PwC) comments that inflation actually varies hugely from this target, even during non-inflationary periods, depending on which factor an analyst uses. In early 2023, for instance, business materials costs indicators are down 20% or more compared to a year ago, while other consumer indicators are now 8-10% higher (still driven primarily by energy costs and automobiles). The UK “CPI” inflation rate peaked last fall and, similarly to the rest of the world, has been dropping slowly since (but food and housing are still rising).

Speaking to business valuers at last week’s ICEAW “Valuation and discount rates in an inflationary environment” webinar, Forrest warned that, “while inflation may be returning to ‘normal,’ the risk of mismatch on inflation assumptions between revenues, costs, and discount rates” remains high.

Business valuers depend on forecasted inflation, so they must also assess key business trends such as supply chain costs, or global transport costs (both of which have dropped to near normal levels in the last two quarters). Annual growth in total pay in the UK increased since 2020, led by private sector increases, given an annual current increase of 5-6% currently.

Meanwhile, bank rates have stabilized. A year ago, the forecast for UK rates was close to 7%. Now, the Bank of England is close to the end of this monetary policy cycle, Forrest reports, with a high predicted near 4.5%. PwC is now forecasting CPI rates to drop below the 2% benchmark in Q2 2024, which suggests that valuers should be cautious about any long term above-norm inflation estimates.

Here are some current business valuation implications from Forrest:

  1. “Inflation need not have a substantial real impact on equity or business valuations going forward.”
  2. Rates will return to the norm for the midterm, as reported by the Bank of England in February.
  3. Inflation pressures are uniquely divergent, so business valuers will need to assess cash flows for individual businesses carefully.
  4. The 10-year and 20-year forecasts currently vary by about 50 basis points. “Business valuers will need to exert consistency when assessing inflation across discount rates and cash flow forecasts.”
  5. Cross-border values will be driven by interest rate tightening going forward, particularly when considering USD assets.
  6. Business values will continue to be driven down in sectors that are price sensitive (accommodations, food, manufacturing, wholesale, etc.) since they will be less able to pass on cost increases to customers.
  7. Nominal gilt yields may still drive higher cost of equity calculation, though the trend here, as elsewhere, is back to normal as 20-year gilt rates trend down toward 3% and below. While the risk-free rate is a bit higher than normal, equity/market risk premia has already “drifted down toward long-term norms of perhaps 5.5%.”

“The classic WACC formula is still driven by components of CAPM that drive the discount rate up,” Forrest concludes, but increasingly the factors are trending down.

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