The Impact of Tariffs on Business Valuation: Part 3 – Implications for Valuators

After reading Parts 1 and 2 of our mini-series, you now have a better understanding of what tariffs are and how they can impact the economy. This blog wraps up our discussion on tariffs by answering the question: why do they matter to business valuators? Similar to the COVID-19 pandemic, tariffs – and the uncertainty that they bring – will undoubtedly impact the approach and assumptions surrounding almost every engagement we take on, from a business valuation to an income for support report.

Business Valuation Reports

As tariffs impact many aspects of business operations, we begin with an overview of the implications for valuation reports.

Earnings

We understand that earnings, for some businesses, may be negatively impacted via a decline in revenue or an increase in costs. Specifically, a business may generate fewer sales if they attempt to pass on additional costs to the end customer, or if they are heavily reliant on foreign sales in the United States. Alternatively, margins may shrink if a business sources raw materials produced in the United States and is required to absorb the additional cost of goods themselves.

Understanding future cash flows is particularly important when utilizing an income approach to business valuations. Valuators may increase scrutiny of management’s forecasts to verify that the impact of tariffs on business operations have been considered. If forecasts are not available, the valuator may need to make several adjustments to historical results, or review interim financials after the announcement of tariffs, to ensure their calculations reflect future expectations.

Working Capital

Valuators will need to assess changes to the industry current ratio – as well as the company’s historic operations – to determine if a working capital injection is required in light of tariffs. In order to stay liquid and reduce the risk of default, companies may prefer to keep more cash on hand. Other key components of working capital that should be closely monitored include:

• Accounts Receivable – Aging schedules may be analyzed to determine if any amounts should be written off as bad debt, particularly from customers who have been hit hard by tariffs.
• Inventory – The fair market value of inventory may need to be reassessed, particularly for products that are subject to tariffs and may become obsolete before they can be sold.

Long-Term Assets and Capital Expenditures

The introduction of tariffs may require valuators to evaluate long-term assets for potential impairment, particularly if taking an asset-based approach. Given the decline in interest rates and changes in the stock market, valuators may need to request updated real estate and equipment appraisals, as well as investment statements, to determine if fair market value is materially different from book value.

Future capital expenditures are also expected to be affected by tariffs. For instance, some companies may need to adjust their operations or strategic direction, leading to the deferral of capital asset investments. Similarly, many business owners may postpone projects, renovations, or environmental initiatives to reduce spending until economic conditions stabilize.

Financing and Contractual Obligations

Tariffs may impact existing debt or lead to contingent liabilities. Valuators may review loan agreements to ensure the business is not breaching its covenants, especially if financial performance has declined. In addition, key customer and vendor contracts should be reviewed by Management to ensure they can be fulfilled. For example, if a business cannot source sufficient inventory or maintain its agreed-upon pricing model, the valuator may need to assess whether any penalties will arise.

Cost of Capital and Valuation Multiples

Increased uncertainty may cause lenders to change interest rates, enforce stricter covenants, and/or require additional collateral, thus increasing the overall costs of carrying debt and further increasing the risk of the company. Similarly, investors will likely require a greater return on equity, particularly for companies operating in vulnerable industries. As a result, valuators may reassess their assumptions surrounding the weighted average cost of capital and resulting capitalization rates.

In general, greater risk typically results in lower multiples and valuation conclusions. While the reasonability of selected assumptions can be assessed relative to observed changes in trading and transaction market multiples, we ultimately stress the importance of discussions between management and the valuator in order to truly understand how the subject company is uniquely affected by tariffs.

Scenario Analysis

A common theme throughout our discussion of tariffs has been economic uncertainty, both in the short-term and long-term. As a result, forecasting financial results, an already difficult task, has become even more challenging for business owners and valuators alike.

If continued volatility is expected, valuators may consider incorporating multiple scenarios into their business valuation reports. These may include base-case, worst-case, and best-case scenarios – each reflecting distinct assumptions. Presenting a reasonable range of values can also be particularly valuable for corporate planning and decision-making.

Stay Vigilant

Going forward, it is crucial to stay informed on the rapidly changing trade policy, particularly for those operating in vulnerable industries. Business owners are encouraged to consult with their trusted advisors (e.g. bookkeeper, accountant, counsel, etc.) to develop mitigating strategies to combat the adverse financial and legal impacts that the tariffs may have. Finally, valuators should proactively assess tariff risk when performing forward-looking valuations and may need to collaborate with other valuators and industry experts to account for unique impacts.

If you have additional questions or concerns regarding the impact of tariffs on your business, please do not hesitate to give the professionals at Davis Martindale a call!