This is due to the fact that valuation is based on what a willing buyer would pay a willing seller. How much the willing buyer is willing to pay depends in part, of course, on the company’s prospects, but it also depends on what else the buyer can do with the money. In a more turbulent economy, with rising interest rates, buyers are less interested in purchasing equity, in general, whether that is stock in public companies or buying closely held companies.
ESOP valuations are determined by the development of a variety of approaches, including the income approach (an assessment of the value of future cash flows) and the market approach (including the public guideline company and the mergers and acquisitions methodologies). For a profitable ESOP, typically one, some, or all of these approaches are weighted in calculating a final value. Because it is often difficult to find truly comparable companies or transactions, the income approach is typically weighted more heavily than the market approach. In the implementation of an income approach, the appraiser determines how much a buyer might pay based on the future cash flow of the company, as adjusted by a discount rate. The discount rate, or cost of capital (weighting both the cost of equity and the cost of debt to determine that cost of capital), is applied to the future or expected EBITDA to reflect the rate of return a hypothetical buyer would require to buy the equity of the company. For the cost of equity, if equities in general are seen as riskier, the buyer will want a higher rate of return. For the cost of debt, high interest rates have the same effect because the buyer has the option of investing in interest-bearing investments with much less risk.
2022 was a difficult year for equity investments. The S&P 500, for instance, dropped 18.2%. Meanwhile, interest rates rose substantially. To calculate the cost of capital that an investor needs, appraisers calculate the weighted average cost of capital, factoring in equity and debt and assigning a weighting to each.
In a presentation to the NCEO’s annual conference in Kansas City in April of 2023, Patrice Radogna of Marcum, James Higgins of Pilot Hill Advisors, and Mike Flesch of Summit Fiduciary Group provided an example of how this affected valuations for 2022 versus 2021.
Table 1 shows the risk-free rate (what an investor would require for risk-free long-term treasury bonds), the equity risk premium (how much more an equity investment needs to be to compensate for the incremental risk above the risk-free rate), the size premium (smaller companies are riskier than big ones), and the unsystematic risk premium (often called the company risk premium, or the added risk for the company being valued based on the degree of uncertainty about future cash flows as well as other company-specific risk factors). The aggregate of these factors (or a total cost of equity) yields a discount rate that will change from year to year based on movements in these various rates.
The second calculation, the cost of debt as shown in Table 2 is simpler. This looks at the cost to the company of borrowing instead of an equity investment. Because a company’s capital structure can be comprised of either equity or debt, the appraiser weights the equity and debt components of a company’s capital structure (based on company or industry factors) to calculate a total (weighted average) discount rate.
The table below shows how the equity discount rate changed from 2021 to 2022 for the sample company, which in this case has a 4% added risk premium. These typically vary in ESOP companies between 2% and 7% with some outliers.
Next, the appraiser has to consider the cost of debt, as of the valuation date.
If all other factors were held constant in the valuation of the sample company, other than the above costs of debt and equity, the market changes alone would reduce the enterprise value of the company by 17%.
Appraisals also examine guideline company multiples. Market multiples dropped as well in most cases, often by a significant amount. While developing value relies on the market approach, the impact can be less in the development of value for a privately held company, to the extent that less weight is assigned to the guideline company methods.
The combination of these market factors means companies could see significant stock price declines that are unrelated to their performance. Of course, this can go the other way too, in better (less risky and volatile) market environments.