2022 ESOP Valuation Expectations and 2023 Transaction Pricing Considerations

Now ends the 2022 ESOP plan year and so begins a new year.  With this annual cycle comes a myriad of contrasting economic, market, and other considerations that will influence new and existing ESOP valuations.  

Newly forming ESOPs must contend with the currently complicated transaction and financing environment while attending to the scrutiny of ESOP Trustees.  The mortal cost of COVID-19, while greatly reduced, still lurks as do the associated financial and operational consequences of the pandemic.  The chaotic aftermath of the pandemic is compounded by geopolitical conflicts that are contributing to elevated inflation, high interest rates, global currency imbalances, volatile financial markets, labor churn, and fears of an impending economic downturn.

2022 Trends and Expectations for 2023 That Might Influence Value

ESOP valuations are primarily driven by future cash flows and how those cash flows satisfy the return requirements of capital providers (lenders and shareholders).  With this in mind, what are some of the overriding trends from 2022 and expectations for 2023 that could influence valuations for 2022 and into the foreseeable future?

2022 Stock Markets

The S&P 500 declined approximately 20% in 2022.  Across broader equity markets, almost every sector of the market experienced a downturn except energy.  Unfortunately for certain businesses, elevated energy and commodity costs likely hindered profit performance through higher operational costs and supply chain inflation.  A primary fundamental for much of the market malaise was higher interest rates, which tempered earnings multiples by approximately 20%-30% in 2022.

The takeaway is that despite higher earnings performance, most bellwether public companies experienced lower stock prices due to lower valuation multiples. Lower valuation multiples result from lower expected growth performance and higher risk; 2022 was a bad year in both regards.

2022 Inflation and Interest Rates 

At the time of this publication, the latest data for U.S. inflation for all consumers shows a year-over-year increase in prices of 7.1% - marking the second year of historically high inflation.  Higher prices have been an acute issue for the Federal Reserve.  During 2022, the Fed Funds target rate increased to over 4% with rate hikes spread over seven adjustments throughout the year.  Monetary policy has a meaningful effect on certain valuation treatments for all companies.

Higher interest rates stemming from rampant inflation represented a core de-valuation force for equity markets in 2022 despite higher earnings for most companies.

Standing in front of shareholders are lenders whose asking price for debt increased significantly throughout 2022.  Yields on investment grade corporate bonds, a frequently used interest rate proxy in business valuations, increased by 2.5% to just under 6% during 2022.  The planet’s largest borrower, the U.S. government, witnessed the yield on 20 yr Treasury bonds increase by 2.2% to over 4.1%.  U.S. Treasury Bond yields were inverted with bond investors effectively charging more for short-term money.  This reflects the marketplace’s concern for near-term economic performance.  

Inverted yield curves have been the harbinger of future recessions for over 50 years; the real question might be when and how deep is the next recession.

2022 Economic Growth and Business Cycle Risk

Real GDP increased 3.2% in the third quarter of 2022 after registering only 0.6% in the second quarter.  Estimates for annual 2022 GDP are 2.0%. Real GDP excludes inflation, which must be added to create a proxy for nominal growth in current dollars.  

The Wall Street Journal’s survey points to a roughly 60% chance of a mild recession in 2023.  Forecasts for 2023 growth are modest to bearish.

M&A Activity and Pricing  

M&A deal volume declined during much of 2022, while EBITDA valuations remained relatively steadfast if not elevated in the second half of the year.  

Observers and users of transaction data are cautioned about the direct use of deal data based on growth and margin disconnects as well as the potentially significant value gap that can exist between financial investors (ESOP FMV) and strategic acquirers in real world business combinations. Historical data may simply be unreliable, particularly in light cyclical concerns.  

Higher borrowing costs and increasing concerns for an economic downturn are contributing to reduced M&A volume. Capital remains plentiful, but costly.

Valuation Synthesis

As can be seen in the table, market effects on income capitalization and discounted cash flow methods, holding all other inputs constant (namely expected cash flows), would result in a lower valuation (down 20%+).

Noteworthy is that while each valuation practitioner employs their own procedural variations to develop the cost of capital, 2022 plan year valuations and newly minted 2023 valuations should reflect the directional realities of the marketplace.

Recall that a few short years ago, The ESOP Report informed its readers that the reduction in corporate tax rates would have a systemic upward impact on valuations (+20%), just as it did on the public stock market during 2017.  

The confluence of current factors represents a similar but opposite potential downward impact on valuations for the 2022 plan year and for transactions into 2023. 

Is My Valuation Destined To Experience A Decrease?  

No, but avoiding a decline likely requires favorable 2022 results and supportable expectations for favorable growth in 2023 and beyond.  

Again, all else being equal, the steep upward trajectory in both equity and debt rates will have a negative impact on value unless cash flows are able to overcome these headwinds.  Further near-term monetary action from the Federal Reserve is intended to foster sufficient demand deconstruction to tame inflationary pressures.  These economic factors suggest that a business needs to boost earnings to compensate for negative market forces to maintain last year’s value.  

Despite the news above, the overall demand in the economy remains relatively strong and businesses have generally been able to pass along the inflationary impacts to preserve margins critical to maintaining or improving profitability.
Conclusion

While it is understandably perplexing that strong 2022 revenue and/or higher cash flows could result in a lower 2022 valuation, the ESOP-owned business universe has historically indexed favorably against broad market performance with favorable growth, higher productivity, and less downside. 

In the current environment, a flat to modestly down ESOP 2022 valuation is a win relative to the performance of many public companies and non-ESOP owned businesses.  

For most ESOP-owned companies this footing should provide a firm base to resume the march ahead.  For ESOP companies experiencing paradigm changes and disruption to their business models, a rebalancing of their valuation is vital to sustaining the best outcomes for participants over the long run. 

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