Brexit and Business Valuations
One year on from the UK referendum, we take a look at Brexit's impact on the economy. What does it mean for company valuations?
Just over a year ago, on 23 June 2016, the UK decided 51.9% to 48.1% to leave the EU. After a closely fought campaign, this was a surprise outcome, especially so for many in the business community who have long benefitted from unencumbered trade within the EU in the largest single market in the world. In the run up to the vote, there were many theories proposed from Leave campaigners about what exiting the EU would actually look like, but nothing concrete. Since that historic date, the UK Government has tried to allay the fears and uncertainty surrounding an exit from the EU, but, as part of their negotiating strategy, have deliberately not given much detail. Following the first formal meeting between David Davis for the UK and Michel Barnier for the EU at the end of June, we look back at what impact Brexit has had on the UK economy and what it means for company valuations going forward.
One thing is for sure: the Brexit process will have a substantial impact on all sectors of the economy in both the UK and the EU, with both winners and losers. As a valuer, it will be critically important to understand both the risks and opportunities so we can see where value may be created or lost.
Volatility and devaluation of the Pound set to continue
The immediate impact was a devaluation of the Pound, which fell some 6% against the Euro and 8% against the Dollar the following day. Both exchange rates have continued to fall since then and are currently 13-15% below where they were on 23 June 2016. Share price volatility also shot up following the vote but eventually came down again. It is highly likely we will experience further volatility as negotiations progress, but for now there is little prospect of a return to pre-Brexit Euro and US exchange rates (bar a sudden and significant increase in UK interest rates).
So what does this mean?
The exchange rate movement has been a double edged sword - a blessing for those companies that primarily sell outside the UK (for example, one high-end UK fashion retailer only generates about 11% of sales from the UK), but a curse for those companies that import raw materials, goods and services from abroad. Some airlines have been particularly affected because of worries that British holiday makers would be put off due to the weaker pound, whilst making fuel (which it pays for in dollars) more expensive.
The knock-on effect of lower exchange rates was two-fold – at the listed company level, we have seen the overall FTSE 100 index move up significantly. There has also been an increase in inflation as imported goods and services have become more expensive.
The FTSE 100 index went from 6,338 on 23 June 2016 to 7,143 at the end of 2016, and is (at time of writing) around 7,400 mark. Commentators have linked this increase to the fall in the pound, as overseas earnings for the international businesses listed on the FTSE translate into higher earnings for UK reporting purposes. One might have suspected listed company multiples to have risen since Brexit, on the basis that there is a lag between companies announcing results and the movement in the equity markets. However, the average price earnings ratio for the FTSE 100 actually fell from 56.4x in June 2016 to 32.7x in May 2017. Over the same period the average EV/EBITDA multiple fell from 14.3x to 11x.
FTSE 100 P/E Multiples versus EV/EBITDA Multiples:
Fewer transactions in the market
What about the transactions market? One reference point is the Private Company Price Index (PCPI), which tracks the EV to EBITDA multiples paid by trade and private equity buyers when purchasing UK private companies. As illustrated in the chart below, the PCPI for deals did not appear to be significantly impacted by Brexit. The average EV/EBITDA deal multiple actually peaked in the last quarter of 2016 at 10.5x, though it has come back down to 10.1x in Q1 2017. The volume of deals did fall in Q3 2016 (with 472 trade acquisitions and 106 private equity acquisitions, compared to 560 and 147 in Q2 respectively), but in Q4, the deal volumes rebounded, before falling again in Q1 2017.
PCPI and Deal Volumes:
Is the negative impact on the economy simply delayed?
The dire warnings of a significant negative impact on the economy did not materialise post-Brexit with GDP growth for the rest of the year still positive at a quarterly rate of around 0.6% and ahead of most developed countries. However, GDP growth in the first quarter of 2017 was only 0.2%, the lowest of all OECD countries. It has become clear that GDP growth in the latter half of 2016 was consumer-driven, but with the savings ratio depleted, consumer confidence low, and inflation now running higher than wage growth, the impact on the economy could be significant, particularly for consumer-facing businesses.
The Bank of England warned that inflation would rise and expected this to go from around 0.3% at the time of the referendum to more than 2.5% for the second half of 2017. As of May 2017, CPI was at 2.9% and likely to continue rising in the short term.
One response to Brexit was that the Bank of England reduced the base rate to 0.25%. But with inflation increasing, and likely to increase further, there is likely to be greater pressure on an upward movement in UK interest rates sooner than would have happened had the Brexit vote not occurred. That would be good news for savers, but after years of historically low interest rates, any material increase could have a significant impact on the economy and on homeowners. This is why Mark Carney, the Governor of the Bank of England is likely to want to wait and see.
Bond yields dropped following the Brexit vote, reflecting the fall in the pound and the expected fall in base rates. Late in 2016 they recovered to some extent when the immediate impact on growth turned out to be less than expected. However, since then they have again come down and current rates are still extremely low.
5-year, 10-year and 20-year UK bond yields:
So what does this all mean for company valuations?
For valuations using a market multiples approach, the impact is likely to be two-fold: on the one hand there will need to be greater scrutiny of listed company performance and their multiples when considering comparability to the valuation subject. At the mid-tier / SME level, these will be privately owned businesses which may generate most of their income in the UK. Taking averages or medians of a basket of listed comparable companies without further consideration may lead to significant under or over-valuation.
When looking at multiples from (historic) comparable transactions (e.g. from before the Brexit vote), some adjustment will be needed when applying to businesses in the current economic climate. Acquisitive businesses that have for years bought businesses on the same multiple of earnings may find those acquisitions being less value-enhancing.
On the other hand, greater consideration will need to be given to maintainable earnings estimates particularly when given historic results may have been achieved in different economic circumstances. Future performance may be significantly different given an environment of low exchange rates, growing inflation, and the possibility of continuing low GDP growth and falling consumer confidence.
For valuations using a discounted cash flow approach, the impact of Brexit may be easier to model in the cash flows, but there is still some subjectivity as to how the current economic circumstances will develop and the Brexit negotiations may impact business confidence. Companies that simply roll-forward last year’s model will need to think carefully whether that is appropriate.
Discount rates will also need to be properly considered. This is both in cost of equity terms such as risk free rates and betas but also the cost of debt which may have been based on historic interest rates and which may increase in the future, in association with market gearing assumptions.
Our view is that while stock markets in general have forged ahead and the transactions market seems for the moment to have continued positively, we are only one year on from that historic Brexit vote and formal negotiations have only just started. The clearer the outcome of those negotiations, the clearer the impact on the economy and on companies and their valuations will be. Forecasting company growth, as part of a valuation, whether in respect of earnings or as cash flows, will continue to be challenging. As Nils Bohr famously said: “Prediction is very difficult, especially if it’s about the future”.