How Do Changing Interest Rates Affect Company Valuations?

As noted in our valuation discussion, when using an annual free cash flow model for determining the enterprise value of a pest control business, one of the key factors used is the buyer’s (i) minimum return on investment (“ROI”) and (ii) such buyer’s cost of capital, all stated as a percentage. The net of the two factors is the buyer “hurdle rate” which is not a standard percentage that all buyers agree on.

One buyer may have a greater desired hurdle rate than another, especially when investment risk is taken into consideration, their borrowing ability and current interest rates, all of which are included in the analysis. The higher the desired hurdle rate then the resulting price a buyer is willing to pay will logically be lower as an offered purchase price is predicated on a multiple of annual free cash flow generated from the targeted business.

To take it to the next level, if one buyer expects a hurdle rate of 15% and their borrowing cost is 8% then the required ROI needs to be 23%.  If another buyer can borrow money at 3% and only expects a net hurdle rate of 12% then the required ROI is only 15%. The disparity between an offer from the two examples explains why purchase price, expressed as a multiple of revenue can range anywhere between 1-3X and have absolutely no correlation from one deal to the next or in any way simply change because interest rates are going up or down, as the case may be.

With this in mind, interest rates generally affect the hurdle rate of a buyer. One would expect that rising interest rates lead to a lower valuation unless a buyer was willing to reduce their expected ROI to keep the purchase price the same.  Conversely, if the cost to borrow goes lower, a buyer may increase an offered purchase price unless they decide a higher hurdle rate is of benefit and therefore the offered purchase price would remain the same.

Bottom Line – interest rates and changes in such rates do affect valuations but the degree to which it is true is dependent on other competing factors that are equally important.