Risk Capital During High Inflationary Periods

Risk Capital During High Inflationary Periods

Valuing any business/asset is a function of #cashflows, growth in cash flow and risks in the underlying cash flows. But, in 2022, with so many changes in macro-economic indicators, from rising inflation in the US to #russiaukrainecrisis to #srilankacrisis, one thing is clear – 𝗙𝗲𝗮𝗿 𝗶𝘀 𝗿𝘂𝗹𝗶𝗻𝗴 𝘁𝗵𝗲 𝗺𝗮𝗿𝗸𝗲𝘁.

We can derive the measure of fear through the discount rate in the #valuation, which prices the risks in cash flow. For example, in a DCF valuation, we discount cash flows using WACC.

WACC = % of debt Cost of debt+%of equityRisk free rate + beta*Equity Risk premium+Country risk premium

In 2022, the following happened:

𝗥𝗶𝘀𝗸-𝗳𝗿𝗲𝗲 𝗿𝗮𝘁𝗲: The global rise in inflation has increased risk-free rates. For instance, the risk-free rate in the US increased from 1.51% on Jan 22 to 3% in July 2022.

𝗖𝗼𝘂𝗻𝘁𝗿𝘆 𝗿𝗶𝘀𝗸: A function of political stability, corruption, and violence has increased sharply for countries in Eastern Europe (Russia, Ukraine war has increased the country’s risk for the entire region), Asia and Africa. The world currently is far more dangerous than at the start of 2022.

𝗕𝗲𝘁𝗮 𝗮𝗻𝗱 𝗖𝗼𝘀𝘁 𝗼𝗳 𝗱𝗲𝗯𝘁: It is a function of firm-specific risk, and businesses with high leverage or that burn cash have witnessed an increase in beta, which explains the flight of risk capital from start-ups/tech firms to safer assets.

As each component of WACC has increased, the price of risk has increased, resulting in higher discount rates and, eventually, lower valuations.

𝗙𝗼𝗹𝗹𝗼𝘄𝗶𝗻𝗴 𝗮𝗿𝗲 𝗺𝘆 𝗶𝗻𝘀𝗶𝗴𝗵𝘁𝘀:

1)Safety is the mantra now. Investors will minimize risk by investing in safer assets (bonds or firms with stable cash flows) and moving their capital from start-ups/ cryptocurrencies/risky investments.

2)Investors will move their capital to safer countries/matured markets (US, Canada, Western Europe and Australia) from emerging markets. Countries having political instabilities/wars will not witness any external investments.

3)Higher inflation will increase the risk-free rate, and, in turn, investors expect higher returns from riskier assets.

We must incorporate the above factors in our valuation as the factors that helped value business earlier have changed if we do not adjust, 𝘄𝗲 𝗿𝗶𝘀𝗸 𝘃𝗮𝗹𝘂𝗶𝗻𝗴 𝗯𝘂𝘀𝗶𝗻𝗲𝘀𝘀𝗲𝘀 𝘄𝗿𝗼𝗻𝗴𝗹𝘆.