Interesting times. Again. How “interesting” remains to be seen.
We have reviewed a number of recent publications (some listed below) regarding the biggest (high probability, high impact) risks in the current environment, which we have tried to summarize shortly here together with their potential impact on valuations. It should be noted that the focus is on main short-term risks, which are often highly correlated, so their combined impact is most relevant here.
Five key risks
- Stagflation (or prolonged recession/high inflation). While there are clear signs for recession already, adding the energy and food crisis, policy risks, and other factors (see below) the risk or prolonged recession or even stagflation is identified as a major concern now.
- Continuing and escalating war in Ukraine. The Russia-Ukraine conflict remains the biggest geopolitical risk in Europe with vast consequences on security, energy, food, commodity supply and prices globally. The possibility for further escalation of the war is not small, which would have a strong effect in 2022 and 2023.
- Policy risks from central banks and governments. The attempts to control the inflation have started with increases of the interest rates. Many governments however plan or already implement policies aiming effectively at supporting the market demand. Overdoing it is seen as a material macroeconomic risk which could further increase inflation, reduce growth, etc. in the next couple of years.
- Debt crisis. The sovereign (but also corporate debt) is at all-time high. According to IMF 30% of the emerging and 60% of low-income economies are in or near distress. This is a major concern, especially when considering the above risk factors together.
Corporate debt (especially of smaller companies) is also significant and would lead to higher default rates in a recession/stagflation environment.
- Supply chain risks. Covid-19 pandemic disruptions and issues with the supply chain are not resolved. Considering also the impact of the Russian sanctions, China’s Zero-Covid Policy, chip shortages, labor constrains and other risks mentioned above, an anti-globalization trend in manufacturing and supply chain has emerged, so material supply shifts and shocks in all sectors could be expected in the next couple of years.
One bonus global risk: Climate impact and regulation. Climate risk will be a major issue in the following years, affecting directly or indirectly all companies on the market. Environmental, social and governance (ESG) and other regulations and targets could be expected to have prolonged impact on most companies. While the transition to greened economy provides material opportunities (incl. by policy stimuli), it will also rise the cost of doing business across sectors.
One bonus local risk for Bulgaria: Political instability and rise of populism. Combining the fragmentation of the political system, the lack of clear majority and consensus on key issues, institutionalized corruption issues and the rise of populist parties, one can expect direct or indirect effects on the market in the next couple of years.
So what is the impact on our work as business appraisers? We would argue that the impact of the above risk factors should be considered when performing business valuation, incl. in:
- income approach: assess the business model of the company and its vulnerability in recession environment, (positive or negative) effects from the war in Ukraine, supplier and client risks, prices, costs and inflation effects, balance sheet and financial structure risks in a high interest rates environment. Consider appropriate macroeconomic projections and risk factors in the cash flows, incl. by using scenarios. Apply properly risk adjusted, forward looking discount rates.
- market approach: evaluate new and higher risks when using multiples, especially when historically derived. In emerging economies, the M&A data, deals and public information is constrained so, the higher risk in historical multiples should be considered and crosschecked with the income approach (if possible).
- cost approach: applying indexed cost, replacement cost and similar methods, might be challenging in high inflation or recession environment with supply chain issues, so this approach (as usual) should be applied in exceptional cases.
- specific sectors, companies and assets might be very challenging to value so “high level”, “one approach for all” valuations would be less reliable in this period.
- due to the material risks in the current environment, additional scenarios, wider valuation ranges with appropriate disclosures (incl. special assumptions, if needed) might be necessary so that the valuation conclusions are put in proper perspective and timeframe.
Sources used include: