It is common to see the value of a business drop during a recession and the assumption is that the decline in value correlates to the decline in P/E multiples. However, that is not the case. What is overlooked is that business value is driven from two key variables: cash flow and risk. At GCF Valuation we have navigated through 2 recessions over the last 23 years. In both instances, the statistics we observed was what one might expect: financial trends declined going into the recession and subsequently rebounded coming out of the recession. So, during a recession what will cause the value of a business to decline?
The answer is two-fold. First, if value is driven from cash flow and risk and cash flow is down, business value will be down as a direct result of the decline in cash flow. The second part of the answer is dependent upon how the business owner is able to manage through a recession. If a business owner successfully reduces costs as revenues decline, cash flow margins remain somewhat stable thus keeping financial risk stable as well. It is the business owner who cannot reduce costs at the same pace as the decline in revenue that will experience an enhanced drop in value. This is because cash flow and cash flow margins are now declining at the same time. Declines in margins increase financial risk. It is this increase in risk that causes P/E multiples to decline. The bottom line: if a business owner can maintain cash flow margins while cash flow is declining, P/E multiples will remain the same.
This content only applies to financial risk and P/E multiples. There are many other risk factors involved in valuing a business that have to be considered as well. If you would like to learn more about how we determine risk, you can connect with GCF Valuation experts at: email@example.com.