Ankura TAS experts discuss current valuation strategies to address interest rate risk and volatility in the current high-rate environment 

One thing is for certain, volatility and change create uncertainty in valuations — how we respond to it is what’s important to understand.

Interest rate volatility can have a significant impact on valuations. That impact can be either positive or negative. Time is also a critical element. Is the volatility expectation short-term or long-term, leading to uncertainty into the foreseeable future?

• On the one hand, higher interest rates make it more expensive to borrow money, which can reduce the demand for assets and lead to lower prices. This is because investors need to earn a higher return on their investments to compensate for the higher cost of borrowing.
• On the other hand, higher interest rates can also lead to stronger economic growth, which can boost corporate earnings and make companies more valuable. This is because businesses typically have more cash flow when the economy is growing, which allows them to invest in new projects and grow their businesses.

The impact of interest rate volatility on valuations will vary depending on the specific asset class or the individual entity. For example, interest rate volatility is likely to have a greater impact on valuations for companies with high debt levels or companies that rely heavily on borrowing to fund their operations.

Here are some specific examples of how interest rate volatility can impact valuations:

Interest rate volatility causes many issues for our clients as well as their auditors, including:

• Increased Risk which leads to investors being hesitant to invest in debt securities. 
• Decrease in Demand for Traditional Credit limits growth opportunities for companies who are unable to borrow through traditional bank loans.
• Earnings Volatility increases risk and impacts investor confidence in companies and the markets.
• Auditor Concerns regarding the quality of values, permanent impairments, and potential for financial misstatement.

Although our clients are responsible for the financial statement presentation, auditors still need to assess evidence and support for fair value marks as part of their process of issuing an audit opinion. As we approach year-end - the aforementioned factors regarding rising interest rates and volatility only increase the need for well-documented valuations. This will be important whether you develop your marks internally or through the use of an independent third party.

In terms of how third-party valuation firms address interest rate volatility, several valuation methodologies can be used. Some of the most common include:

Discounted Cash Flow (DCF) analysis: DCF analysis is a valuation method that calculates the present value of future cash flows. This method can be used to value a company's equity or debt.

• To account for interest rate volatility in a DCF analysis, investors can use a variety of techniques. One common technique is to use a range of interest rate assumptions. This allows investors to see how the valuation changes depending on the level of interest rates.
• Another technique is to use a discount rate that is adjusted for interest rate volatility. This can be done by using a forward curve to estimate future interest rates. Over the past 3 years, rates have changed significantly, as well as the structure of the yield curve.  See chart below:

*As of end of November (each year). 

Source: https://home.treasury.gov/policy-issues/financing-the-government/interest-rate-statistics

• The chart above demonstrates how volatile interest rates have been recently.  From one year to the next, the impact on valuations can be significant.

Real Options Valuation: Real options valuation is a method that considers the flexibility that companies have in their operations. This method is often used to value companies in industries that are subject to rapid technological change or regulatory uncertainty.

• To account for interest rate volatility in a real options valuation, investors can use a technique called Monte Carlo simulation. This technique allows investors to model the possible outcomes of a company's future cash flows under different interest rate scenarios.

Comparable Company Analysis: Comparable company analysis is a valuation method that compares a company to other companies in the same industry. This method can be used to value a company's equity or debt.

• To account for interest rate volatility in a comparable company analysis, investors can use a technique called beta adjustment. This technique adjusts the company's beta to reflect the level of interest rate risk in the industry.

Asset-Based Valuation: Asset-based valuation is a valuation method that values a company based on its assets. This method is often used to value companies that are in financial distress or have significant fixed assets and intangible assets.

• To account for interest rate volatility in an asset-based valuation, investors can use a technique called present value of future cash flows. This technique calculates the present value of the company's future cash flows derived from its assets.

No valuation methodology is perfect, and all the methods mentioned above have their own strengths and weaknesses. Investors should consider their investment goals and risk tolerance carefully before choosing a valuation methodology.

Overall, the impact of interest rate volatility on valuations is complex and depends on a number of factors. Investors should consider the potential impact of interest rate volatility on their investment portfolio carefully before making any investment decisions.