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As rates rise, it’s time to better manage your business risks: Part 1

October 25, 2022

Rates, Risks And Your Pharmacy’s Value: Part 1
Central banks are waging war on inflation, and we are all paying the price. Borrowing costs have gone up sharply for consumers and business alike as monetary policymakers hike benchmark interest rates, and there is likely to be more pain to come. Higher rates are dramatically changing the landscape for corporate earnings, financial markets and the broader economy. But as business valuation experts, we here at Evcor would also note that rising rates have another potential impact: they tend to undermine a company’s market value.
It's not hard to see why: a higher-rate environment works against the value of every asset class, including businesses. That’s because increasing borrowing costs increase risk. If you bought a business by borrowing at 1% two years ago and the acquisition failed, you wouldn’t be out very much – just that 1%; if you buy a business today and it fails, your losses on interest could be four, five or six times higher. Now think about a basic valuation formula, which derives value by dividing recurring cash flow by the rate of risk. All else being equal, the value you come up with goes down when the risk rate goes up. It’s simple math.

Be Prepared

How long and how high rates will continue to rise is anybody’s guess, but it is becoming increasingly clear that the days of cheap borrowing costs might be ending. As business transaction advisors, we have yet to see a dramatic slump in valuations or transaction activity; we have not reached the depths of the 2008-2009 recession – at least not yet. That’s the good news. The not-so-good news is that central bankers probably aren’t done hiking rates, and their track record tightening policy without plunging the economy into recession is not exactly heartening. Asset prices – stocks, bonds, real estate, businesses and everything else – could be in for rougher days ahead.

What Shoud You Do?

If you are a business owner contemplating selling your company, then this might seem like very bad timing indeed, since there is not much anyone (other than central bankers) can do about higher interest rates. Yet in our view, this is not the time for despair or complacency, nor does it make sense to simply throw up your hands and surrender to a lower valuation for your business. Quite the opposite. Now more than ever, it makes sense to focus on the valuation factors you can control. And the most important way to do that is to better manage risks.
Higher rates raise a potential buyer’s cost of capital – the return needed to justify a capital expenditure – and that elevated risk rate does lower the market value of a business asset, all else being equal. But “all else” does not have to be equal. If a business owner can lower the risk in the company, then they are effectively working to support and enhance the company’s value. Remember: the lower the risk rate a potential buyer applies to your business, the more they will be willing to pay for it.
The first step is understanding how risk affects your business’s value. The last, is deploying strategies to mitigate those risks as much as you possibly can. In our next blog, we’ll take a closer look at the common risks that impact business valuations and suggest a few ways owners can effectively address them.
 
Contact EVCOR today to learn more about our Pharmacy Transaction Advisory Services
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