The valuation of a business is highly dependent on the economic conditions at the time of sale. When economic conditions are strong, valuations tend to be higher. When the economy is weak or uncertain, valuations tend to be lower. As an owner or potential buyer of a business, it’s important to understand how to properly adjust valuations based on the current economic climate.

In this comprehensive guide, we’ll cover key factors that impact valuation, methods for adjusting valuations, and tips for owners and buyers when assessing a business’ worth during different economic conditions. With the right approach, you can determine fair value even as the economy fluctuates.

Table of Contents

– Key Economic Factors Impacting Valuation

– Adjusting Valuations in Strong Economies 

– Adjusting Valuations in Weak Economies

– Special Considerations During Recessions

– Tips for Business Owners During Changing Conditions 

– Tips for Buyers During Changing Conditions

– The Importance of Professional Valuations

– Conclusion

Key Economic Factors Impacting Valuation

There are several key economic factors that can impact a business’ valuation:

Interest Rates

Interest rates influence valuations in a few key ways. Low interest rates make it easier for buyers to obtain financing, increasing their purchasing power. Low rates also reduce the cost of servicing debt for the business being acquired. Higher interest rates have the opposite effect, making financing more costly.

Credit Availability

When credit is widely available, buyers have increased capacity to fund acquisitions. When credit is tight, buying power is reduced.

Inflation/Deflation

Inflation reduces the purchasing power of a dollar over time. During periods of high inflation, buyers must factor in expectations of rising costs and diminishing profit margins. Deflation has the opposite effect.

Consumer Confidence 

Consumer spending habits directly impact most businesses’ performance. When confidence is high, valuation multiples expand. When confidence drops, multiples contract.

Business Cycle Stage

Valuations fluctuate depending on where an economy is in the business cycle. In the growth and peak phases, valuations tend to rise. In the contraction and trough phases, valuations decline.

Industry Trends

Within any economic cycle, some industries perform better than others. Valuations for a specific business reflect both overall conditions as well as the performance of their particular industry.

Adjusting Valuations in Strong Economies

When economic conditions are strong – low unemployment, rising GDP, high consumer confidence – business valuations tend to be higher. Here are some ways to adjust valuations during strong economic times:

– Use higher valuation multiples. Multiples like price-to-earnings ratios tend to expand during strong economies. Comparable businesses will benchmark higher multiples, so it’s appropriate to use higher multiples for the subject company.

– Factor in expected growth. With a strong economy, most well-run businesses experience growth in revenue and profits. Use projected performance rather than historical performance when applying multiples.

– Account for high inflation. Adjust profits to account for inflated historical earnings. Factor in expectations for higher inflation going forward. This avoids overstating value.

– Consider stage of business cycle. Even in strong economies, at some point growth will slow. Use caution when applying multiples if the cycle is nearing its peak.

– Review financing availability. Easy financing access during strong economies is fading when the cycle peaks. Ensure the buyer has adequate equity and ability to obtain debt at acceptable terms.

Adjusting Valuations in Weak Economies 

During periods of economic uncertainty or contraction, business valuations tend to be lower. Here are some valuation adjustment tips:

– Use lower valuation multiples. Weak economies correlate to lower multiples. Evaluate comparable transaction data from within the current cycle.  

– Weight recent performance. Put less emphasis on high-performing historical financials vs. most recent results. Recent results better reflect current conditions.

– Factor in negative growth. Many businesses experience declining revenue and profits during weak economies. Use projections reflecting this reality when applying multiples. 

– Account for deflation. Avoid understating value by factoring in deflation’s impact on increasing real purchasing power over time.

– Consider buyer motivation. Strategic buyers may still pay reasonable valuations if the target strongly complements their portfolio. 

– Assess financing. Ensure buyers have adequate equity and access to affordable debt financing even during tight credit markets.

Special Considerations During Recessions

Recessionary periods create particularly challenging conditions for business valuations. Here are some special considerations:

– Use recessionary benchmark data. Valuation metrics fall significantly during recessions. Use transaction data from within the recessionary climate.

– Evaluate earnings volatility. Profits often decline or become volatile during downturns. Factor in uncertainty and weight valuations toward tangible assets.

– Assess cyclicality. Cyclical businesses follow economic cycles closely. Use projections reflecting recession effects for cyclical companies. 

– Review fixed assets. Asset values like property, plant, and equipment may decline in recessions. Use appraisals based on depressed market values. 

– Consider intangibles. Brands, patents, and other intangibles often lose value during downturns as consumer behaviour changes. Discount these assets appropriately.

– Calculate liquidation value. Estimate potential liquidation proceeds in case the business fails. Factor in distressed-level valuations for assets.

Tips for Business Owners During Changing Conditions

For owners selling a business, here are some valuation tips during different economic conditions:

– Strong economy: Consider selling to maximise value. Be prepared to negotiate based on rising valuation multiples.

– Weak economy: Delay sale if possible until conditions improve. Or accept a lower valuation based on weakened multiples.

– Recession: Assess if selling now is essential. Be flexible on price and terms if buyers perceive high risk.

– Any conditions: Keep quality financial records current. Maintain and summarise key business data that affects valuation.

– Any conditions: Set expectations early with any advisors or appraisers on how economic conditions will impact value.

– Any conditions: Model potential valuation ranges factoring in economic influences. Avoid over-valuing based on peak performance.

Tips for Buyers During Changing Conditions

For buyers acquiring a business, key valuation tips include:

– Strong economy: Exercise caution to avoid overpaying. Scrutinise seller valuation methods and assumptions.

– Weak economy: Take advantage of lower valuations. But avoid unrealistic expectations on post-acquisition performance. 

– Recession: Consider pausing major acquisitions until conditions improve, if feasible. Be conservative in modelling recovery projections.  

– Any conditions: Partner with financing sources early to assess debt capacity and interest rates.

– Any conditions: Carefully evaluate seller financial data quality. Normalise as needed to determine true base performance.

– Any conditions: Develop valuation models factoring in economic conditions. Perform sensitivity analysis on assumptions.

The Importance of Professional Valuations

For buyers or sellers of mid-market businesses and larger, obtaining a professional independent valuation from a qualified advisor is critical. Key benefits include:

– Objectivity – Avoid over-optimism or pessimism from parties wanting to maximise or minimise value.

– Expertise – Appraisers know the most relevant valuation methods and how to apply them.

– Data access – Professionals have comprehensive transaction and financial data for industry benchmarking.

– Credibility – Independent valuations hold up better if ever scrutinised.

– Negotiation aid – Objective third-party valuations facilitate negotiations between buyers and sellers.

Even during rapidly changing economic conditions, professional appraisers can apply the appropriate adjustments to determine fair market value.

Conclusion

Economic conditions significantly influence valuations, so adjusting for factors like growth, inflation, business cycles, and industry trends is essential. During strong economies, valuation multiples expand, while weak economies cause multiples to contract. Recessions require special considerations like assessing valuation volatility, cyclicality, and liquidation value. Both buyers and sellers need flexibility and objectivity when assessing a business’ worth across the economic spectrum. Obtaining independent professional valuations, despite their cost, provides critical objectivity and methodology to determine fair valuations even in turbulent times.