The Impact of High Interest Rate on Valuation

The Impact of High Interest Rate on Valuation

Post Covid, Interest rate has shot through the roof. All indicators are pointing to the fact that Interest Rates will remain high. What ever the rational of central banks, high interest rates are here to stay. It’s the new reality.

A high interest rate makes the economy slowdown and many edge it closer to a recession as a result. EU, UK are both struggling and the USA is facing its own challenges resulting even in banks to collapse.

A high interest rate attracts investment in risk free assets class. There is a tendency to go for deposits and Sovereign Bonds. There is a flight to safe investment at the expense of equity. The opportunity cost of investing in riskier asset classes has gone up.  It is a vicious circle with other riskier investments having to look for even higher returns which can only be provided by taking higher risks.

According to the Financial Times 31Oct23, “New listing flops drain optimism for IPO market revival” it refers to a large number of IPO which has flopped. “Many investors are demanding a steeper discount to make up for the increased risk of investing in newly listed groups”

A high interest rate environment increases the Risk Free Rate. This escalates the discount rate and it diminishes the value of future earnings. In the event, there is debt involved in the project, the cost of capital will increase because cost of debt is now more expensive. Therefore, as a consequence valuation heads south because of these two factors alone regardless of the cash generated from operations.

The other variable which impacts a valuation is the Equity Risk Premium - The equity risk premium is the additional return that investors expect to earn for taking on the risk of investing in equities over risk-free investments. In a rising interest rate environment, the premium may be adjusted downward due to lesser demand for equity. This outweighs partially the increase in discount rate.

However, the valuation must also take into account the specificity of the industry in which the business operates. 

BANKS: Banking is likely to benefit from high interest rate and its valuation is bound to increase as profits will skyrocket unless it has a deteriorating asset portfolio or it holds bonds whose value go down when interest rates go up. This is not helped with mark to market valuation and the experience of the collapsed Sillicon Valley Bank, 16th largest in USA, rings loud. As per the Financial Times of Nov 01.2023, there is a digital bank in UK called ATOM.  Last year it was valued at £435m. Its latest fund raising put the valuation at £362m. This is due to high interest rate and weak investor sentiment.

FMCG: The main purpose of raising interest rate is to curtail inflation by making credit expensive. It does make demand more expensive and FMCG is usually in the front line of reducing demand.

PROPERTY: This is a business which is directly corelated to interest rate. It impacts Rental Yield, it impacts demand for new properties and adversely impacts construction costs. Refinancing becomes even more difficult.

High interest rate has also hit Private Equity as Leverage Buy Out becomes expensive, refinancing has become challenging and exits are difficult because of weak investor’s sentiment. They can also defer the exit and kick the can down the investment horizon.

Fair Value reporting in financial statements has added another complication in financial reporting. The basis of valuation of assets held privately is not disclosed and often comparisons with listed shares are done but as a relatively skewed method. The litmus test of the valuation will come when the assets are realised: either there will be no taker or it will result in realised losses.

Currently ESG is at the forefront of all valuation discussions. Aswath Damodaran and Bradford Cornell of NYU Stern School of Business in a paper Valuing ESG: Doing Good or Sounding Good? Concluded:

“The evidence that investors can generate positive excess returns with ESG-focused investing is weak, and there is no evidence that active ESG investing does any better than passive ESG investing, echoing a finding in much of active investing literature. Even the most favorable evidence on ESG investing fails to solve the causation problem. It appears just as likely that successful firms adopt the ESG mantle as adopting the ESG mantle makes firms successful.”

At the end of the day, valuation remains subjective even though it is data driven. The challenge is which data is used. In spite of data being used, a valuation is never factual; its not a science; it remains an art.