Some owner-entrepreneurs spend quite a bit of time wondering when it will be the right time to sell their business. This is understandable as it is a critical decision that will probably have the biggest impact on their wealth crystallization. With the US Fed raising interest rates for the first time in ten years, this conundrum is worth revisiting.
When we say Macro vs. Micro, in this case we will examine the impact of higher interest rates versus a specific company’s growth record and prospects. High revenue growth typically means a high valuation and, while not an exact science, higher interest rates generally mean lower company valuations. Higher interest rates result in lower valuations for a number of reasons including: (i) they raise the discount rate used in calculating a company’s value, (ii) they make other more secure investment options more attractive and, (iii) for companies with debt, they lower earnings.
While you would expect a rise in interest rates to affect all companies equally. In fact, some companies have growth prospects quite independent of macro trends (technically called high alpha companies) while others are affected more by general economic circumstances (technically called high beta companies). Let’s look at two scenarios.
Let’s say a growing company is generating $5 million in EBITDA this year and expects to achieve $7 million next year (40% growth). The prevailing multiple for this business is currently 7 times EBITDA. The owner is wondering should he/she sell now for $35 million or hold off and try for closer to $50 million next year. At the same time interest rates have just started to go up, and by next year they are expected to be 2% higher than they are today, which will result in a one times lower multiple. Now he/she is looking at 6 times $7 million in EBITDA which is $42 million. Is it worth the wait? In this case it may be but now let’s at a lower growth, high beta company. Again, the company is generating $5 million in EBITDA this year, but in this case expects to achieve $5.5 million next year (10% growth). The prevailing multiple for this business is 5 times EBITDA and, with higher interest rates, the value now changes from $25 million to $22 million after interest rates rise. Many factors go into realizing value but these scenarios illustrate the point.
So how quickly will interest rates rise? The following chart provided by Capital Economics suggests the Fed funds rate will exceed 3% by the end of 2017.
Owner-entrepreneurs are generally optimistic that next year will be better than the current year and that their companies will be worth more in the future. For high-growth, alpha type companies this is generally true but, if your company is mature and a high beta type company, I would watch rising interest rates carefully because they will erode value.