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How Will the Fed Interest Rate Increase Affect Business Valuations?

How Will the Fed Interest Rate Increase Affect Business Valuations?

June 16, 2022 - On June 15, the Federal Reserve approved an interest rate increase of 0.75%, the largest increase since 1994. This will increase the Feds benchmark federal funds rate to a range of 1.5% to 1.75%.

While rate hikes like this aren’t common, it appears the fed will continue raising rates to combat inflation. New projections place the federal funds rate at 3.375% by the end of the year.

This is a new world for business owners who have spent many years operating in a low interest environment, and many are asking “How will this impact the value of my business?”

The answer is twofold, but both tend to lower business valuations for most businesses.

Asset Demand

As investors judge where to invest their dollars, they are always trying to balance their investment risk versus their return. In recent years, rates of return on “safe assets” like savings accounts and treasury bonds were returning next to nothing for investors so they invested their dollars in equities, looking to generate a higher return. As we begin to see interest rates raise, the risk/return balance changes and investors again may be more willing to place money in these safer investments. More money held in treasury bonds or savings accounts means there is less money to invest in businesses—and as the demand falls. so will the value of those businesses.

Cost of Capital

Another reason we will see business values fall is due to increasing costs of capital. The recent years of cheap debt meant that companies could borrow large amounts to invest in growth projects at a minimal impact to margins to help facilitate returns. Now as interest rates raise, interest expense will go up accordingly and cut into margins. This means that businesses will either invest similar amounts as before, at lower profitability due to increased interest expense, or reduce their investments in growth projects in an effort to keep interest expense at acceptable operating levels.

If you’re looking to transition the ownership of your business, be sure to talk to an advisor to help you understand how changes in the economy and interest rates might affect your transition strategy.

 

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