Business valuation multiples are one of the most widely used methods to assess the value of a company in a merger and acquisition (M&A) transaction. They are ratios that compare the market value of a company to a financial metric, such as earnings, revenue, cash flow, or assets. For example, the EBITDA multiple is calculated by dividing the enterprise value of a company by its earnings before interest, taxes, depreciation, and amortization (EBITDA). Business valuation multiples are useful because they provide a quick and easy way to compare the relative value of different companies in the same industry or sector. However, business valuation multiples are not static and can change over time due to various factors, such as market conditions, industry trends, and economic cycles. One of the most important factors that can affect business valuation multiples is the level of interest rates. In this blog post, we will explore how higher interest rates can have a negative impact on business valuation multiples in M&A deals.
Interest Rates Affect Cost of Capital
Interest rates are the price of borrowing money. They are determined by the supply and demand of credit in the market, as well as by the monetary policy of the central bank. Interest rates have a direct influence on the cost of capital, which is the minimum required rate of return that a company or an investor must earn on an investment. The cost of capital consists of two components: the cost of debt and the cost of equity. The cost of debt is the interest rate that a company pays on its borrowings, such as loans or bonds. The cost of equity is the return that a company’s shareholders expect to receive on their investment, which reflects the risk and opportunity cost of investing in the company. The cost of capital is usually calculated as a weighted average of the cost of debt and the cost of equity, known as the weighted average cost of capital (WACC).
Higher interest rates increase the cost of capital for both the target and the acquiring company in an M&A deal. This is because higher interest rates make borrowing money more expensive, which increases the cost of debt. Higher interest rates also increase the cost of equity, because they raise the risk-free rate, which is the return that an investor can earn on a riskless investment, such as a government bond. The risk-free rate is used as the base rate to calculate the cost of equity using models such as the capital asset pricing model (CAPM). The CAPM states that the cost of equity is equal to the risk-free rate plus a risk premium, which reflects the additional return that an investor demands for investing in a risky asset, such as a stock. The risk premium is calculated by multiplying the beta of the stock, which measures its sensitivity to the market movements, by the market risk premium, which is the difference between the expected return on the market portfolio and the risk-free rate. Therefore, higher interest rates increase the cost of equity by increasing the risk-free rate and the market risk premium.
Interest Rates Affect Cash Flow
Higher interest rates affect the cash flows and growth prospects of the target and acquiring companies in an M&A deal. Higher interest rates reduce the cash flows of the target company by increasing its interest expenses, which reduce its net income and free cash flow. Higher interest rates also reduce the growth prospects of the target company by making it harder to invest in new projects or expand its operations, as the hurdle rate for accepting a project increases with the cost of capital. Higher interest rates reduce the cash flows of the acquiring company by increasing its financing costs, which reduce its earnings per share (EPS) and dividends. Higher interest rates also reduce the growth prospects of the acquiring company by limiting its ability to pursue new acquisitions or organic growth opportunities, as the cost of capital increases with the level of debt.
Interest Rates Affect Valuation Multiple
Higher interest rates reduce the present value and the multiple of the target company in an M&A deal. The present value of a company is the sum of the discounted future cash flows that the company is expected to generate over its lifetime. The discount rate used to calculate the present value is the cost of capital, which reflects the risk and return of investing in the company. Higher interest rates increase the discount rate, which reduces the present value of the company. The multiple of a company is the ratio of its market value to a financial metric, such as EBITDA. The multiple of a company is inversely related to its discount rate, which means that a higher discount rate implies a lower multiple. Therefore, higher interest rates reduce the multiple of the company by reducing its present value.
There is empirical evidence and examples of how higher interest rates have influenced M&A activity and valuation multiples in the past. According to a study by McKinsey & Company, the average EBITDA multiple for global M&A deals declined from 14.3x in 2007 to 8.9x in 2009, following the global financial crisis and the subsequent increase in interest rates. The study also found that the average EBITDA multiple for global M&A deals increased from 9.8x in 2012 to 12.2x in 2017, following the recovery of the global economy and the decrease in interest rates. Another example is the recent M&A deal between Canadian National Railway and Kansas City Southern, which was valued at $30 billion, or 18.3x EBITDA. The deal was financed with a mix of cash and debt, with an interest rate of 4.2% on the debt portion. However, if the interest rate had been 1% higher, the deal value would have been reduced by $1.8 billion, or 6%, and the EBITDA multiple would have been reduced by 1.1x.
In conclusion, higher interest rates have a negative impact on business valuation multiples in M&A deals. Higher interest rates increase the cost of capital, which reduces the cash flows and growth prospects of the target and acquiring companies. Higher interest rates also reduce the present value and the multiple of the target company, which makes the deal less attractive and profitable for the acquiring company. Therefore, M&A practitioners and investors should be aware of the implications and challenges of higher interest rates for M&A deals, and adjust their valuation and financing strategies accordingly. Some of the recommendations and tips for M&A practitioners and investors in a high-interest rate environment are:
- Use more cash and equity, and less debt, to finance M&A deals, as debt becomes more expensive and risky
- Focus on quality and value, rather than quantity and price, when selecting M&A targets, as valuation multiples become lower and more volatile
- Seek synergies and cost savings, rather than revenue growth, when integrating M&A targets, as growth opportunities become scarcer and more competitive
- Diversify and hedge the interest rate risk, using instruments such as swaps, options, and futures, to protect the value and returns of M&A deals