Every investor has a choice on where to invest his or her money
While I was preparing for ZweigWhite's AEC Mergers & Acquisitions Summit in December, I looked at the performance of the ZW15, an index of 15 firms that are publically traded on U.S. exchanges. As I pondered what was driving the values of the individual firms up or down, it struck me that in our current economic situation, we could see a strong recovery in earnings during the next two to three years and not see a recovery of valuations in line with the increase in earnings. How can that happen? The answer is simple — rising interest rates.
The basic theory of valuation is that a firm's value is based on its future cash flows. In practice, valuation practitioners, investors, and investment bankers primarily use the Discounted Cash Flow method to value a firm. This method takes the future cash flows of a firm and discounts them according to the firm's cost of capital. A more simplified method that is easier to explain and illustrate my point is to capitalize a firm's cash flow by dividing it by its cost of capital. Essentially, you have a sustainable future cash flow in the numerator, and in the denominator you have the capitalization rate, which is the firm's cost of capital minus its long-term growth rate:
Free cash flow/(Cost of capital – Long-term growth rate)
What does all this have to do with interest rates? A firm's cost of capital is dependent on interest rates. There are two components to a firm's cost of capital — the cost of equity and the cost of debt. The cost of debt is easy to determine because your bank tells you what rate you will pay them on any borrowings. Obviously, as interest rates rise, so does the cost of debt.
Many firms in the AEC industry are debt free, so they think that they are immune to increasing interest rates when it comes to valuation issues. Those who think that, think wrong. The cost of equity is determined by looking to public equity markets to determine the premium that an investor should receive to invest in the equity of a firm. Every investor has a choice on where to invest his or her money. The minimum return an investor should receive is set by a "risk free" investment, which is considered by the investment community to be U.S. Treasury Bonds. As rates on U.S. Treasuries rise, so does the cost of capital for all firms. Since the cost of capital is in the denominator, a rise in interest rates decreases the value of a firm.
What would rising interest rates mean to the value of your firm? As is typical, the answer is, "It depends." If interest rates are increasing and your earnings are stagnant, then the value of your firm will drop. If you are able to grow earnings at a greater magnitude than the increase in interest rates, then the value of your firm will increase.
Typically, interest rates rise when the Federal Reserve Board responds to an economy that is growing faster than it prefers. Hopefully, an improved economy will result in increasing earnings that trump any increase in rates. The worst-case scenario is increasing interest rates that are driven by the dysfunction of the U.S. government. In this case, our inability to fix our fiscal woes causes investors to demand higher returns for investing in U.S. debt. This will cause an increase in the cost of both debt and equity and, unlike a Federal Reserve-driven increase, it may come without a growing economy.
W Hobson Hogan, a principal at ZweigWhite, assists AEC firms with strategy formulation and ownership transfer issues, including buyer and seller representations.
Contact him at email@example.com.