This article has been specifically written for the small business owner.
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On May 22nd 2015 the Labor Department announced that the core CPI increased 0.3 percent, which represents the largest gain since January 2013. As a result of the CPI report, the Fed Fund Futures is now pricing in a 100% chance of a rate hike before year end.
All else being equal, the value of small businesses will decrease when the Federal Reserve increases interest rates. Presumably all else will not be equal at the time the Fed raises rates. The Fed has stated that it will only raise rates when the economy is on a solid footing, as measured by key economic indicators. Hopefully the economic improvement has resulted in an increase in your company’s value sufficient to offset decline in value due to interest rate increases. That stated, the U.S. economy has seen upward momentum for six years and most businesses have now exceeded their 2007 earnings.
Articles with titles such as “The Biggest Threat to Stocks are a Fed Rate Hike” seem to be one of most popular topics these days. So why is Wall Street so nervous over a rate hike and why should you, the Business Owner, also take note? One of the drivers of the bull market has been the Fed’s policy of near zero rates since 2008.
Factoid: Since World War II there have been 16 cycles during which interest rates were raised and over 80% of the time, the stock market suffered a blow when the Fed raised rates. But, more importantly;
Low interest rates have also been one of the principal drivers behind favorable valuation multiples and these low interest rates are soon to rise causing downward pressure on valuations.
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INCREASED INTEREST RATES EQUAL LOWER VALUE
All else being equal, when interest rates go up the value of businesses go down. This includes the value of lower mid-market businesses (generally classified between $5M – $100M in value). How much the value will go down in part depends upon the amount of debt available to the buyer in a potential transaction (i.e. the leverage amount) as well as the the buyer’s required return on equity. Commenting on the increase in the CPI, Todd Hedtke, Vice President for Investment Management at Allianz Investment Management, states, “I think it’s a decent sign for the economy. I don’t think it’s a good sign for capital markets.”
The required return on equity goes up with interest rates because equity investments compete with debt investments. The higher the interest rate on debt, the higher the required return on equity needs to be in order to attract investors. Stated another way, as interest rates rise investors are more attracted to fixed income investments, which in turn reduces the amount of capital available for equity investments. In order for a company to attract equity investment the company’s perceived future prospects must increase and/or perceived risk must decrease. The combined costs of equity and debt, called the Weighted Average Cost of Capital (WACC), are used to discount the company’s future expected cash flow and establish on measure of a company’s value.
When WACC increases 1%, what happens to the value of a small business? A typical company with $30M of Revenue and $3M of Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA) growing at a compound annual growth rate of 5% (the “Model Company”) will lose $945,000 (6.7%) of its value, from $14,038,000 to $13,093,000, with the EBITDA multiple decreasing from 4.91 to 4.5 (refer to below chart).
Impact of 1% rise in interest rates on typical company
with $30M Revenue, $3M EBITDA and 5% CAGR (the “Model Company”)
|Before 1% Increase in Rates|
4% cost of debt, 23% cost of equity
|After 1% Increase in Rates|
5% cost of debt, 24% cost of equity
|TTM EBITDA Multiple3||4.91||4.58||-33.0%||-6.7%|
- Enterprise Value: Equity + Debt
- WACC: Weighted Average Cost of Capital
- TTM EBITDA Multiple: Trailing Twelve Month EBITDA Multiple
As illustrated in the chart above, the $30M Model Company will lose $945,000 (6.7%) of its value as a result of a 1% increase in interest rates.
The Federal Reserve has made it clear that they will raise interest rates only when it is confident that the economic recovery is robust and companies have regained the ability to raise prices.
Per our analysis, if the Fed were to raise interest rates by 1%, from the current .13% to 1.13%, in order to maintain the current value of the business, the modeled $30M company will need to increase its operating profit by approximately 7.2% to compensate for a 1% rate increase.
Don’t panic quite yet. Interest rates are not going up overnight. U.S. Federal Reserve Vice Chairman Stanley Fischer said the process of returning to a more normal level of interest rates will take a few years. Last week the Federal Funds Rate closed at .13 percent. Fed economists expect the rate will reach from 3.25 percent to 4 percent in three to four years. Will that mean that our Model Company will go down in value proportionally more? Probably not, for two reasons:
- Although the interest rate at which businesses borrow moves with the Fed Funds Rate, they do not necessarily move proportionately and
- As previously stated, the Federal Reserve is expected to raise rates with a growing economy. A growing economy generally translates into an increase in the value of small business.
Take note, there can be and most likely will be a lag between an increase in rates and an increase in valuations. This means that Business Owners who do not have a longer term time horizon, at least five years to outlast a cycle, should consider the impact of a rate hike on the value of their business and the timing of an exit. Keep in mind that even after you decide to start the exit process, between getting valuations, choosing an investment banker and executing the selling process, you are easily looking at 1 to 2 years.