Lessons Learnt in Great Recession: Valuing Businesses in Bad Economy

The global economic world is characterised by an endless cycle of busts, booms and rebounds that grapple with the two. Observation and analysis of both capitalistic economies like the United States and Japan, and Socialistic economies like Sweden and Norway, show that both kinds of economies go through these cycles. When economies are between the boom and bust periods, they often face poor valuations and economic conditions. analysing bad valuations in the ‘Great Recession’ between 2007 and 2009, and specific instances in periods before that, could give us some insight into why this is so.

Misallocation and over expectation lead to poor valuation

Over the last few decades, a very clear pattern has emerged. When the economy is enjoying a healthy boom and enough cash is flowing through the system, there is a flurry of expansion activities. Thanks to credit availability at lower interest rates, businesses grab the cash and pump it into their companies, overvaluing returns and setting high expectations, in terms of profits.

This is a classic case of availability of relatively easy credit leading to bad investments and short-sightedness. As was clearly the case during the real estate boom or even the dot com boom, in the 1990s.
Businesses that stand the vagaries of time are often built on a demand and supply principle. Businesses that are built on speculation and the availability of credit alone, offer the classic foundation for poor valuation. With time, this poor valuation and the unsound planning are revealed, and the market corrects itself. As it did in the case of real estate, in the Great Recession. There is a rush to liquidate assets, cut losses and get out quickly, because profits are not forthcoming and neither is credit.

Companies that are in the early stages of existence, like most of the dot com companies were aren’t able to justify their existence in busts, because there was no demand for their products or ‘outputs’. This, along with tight credit during downturns, leads to a severe cost crunch which makes it hard to fund ‘inputs’ for the business, like production, capital and other costs. This is when start-ups go bust and larger companies tighten their belts, cutting production and firing employees.

The cycles of boom and bust are then, self-created by the business world. Turns out that poor planning is bound to happen, where resources are improperly allocated, based on speculation, and not on demand or requirement of the output. Is this all a result of bad business plans? Because plans are expectations of the business performance, based on capital, talent and other inputs, and the outputs that these inputs will lead to. Reaction to these failed plans, often a rush to make up for the losses caused by wrong asset pricing models lead to business debacles and in the larger context, financial crisis. The situation is further worsened by outputs that were in demand during the boom period, experiencing lowered demand during the bust period.

Buying & selling screeches to a halt

No thanks to poor business valuations, the M&A industry takes a hit too.
Companies are held back from mergers or feel dissuaded to acquire companies that might seem like a good deal, as they have no clear picture of the future ahead. Although businesses know that a boom is inevitable, in downturns they are unable to place their bets on when this will happen. Thus the Mergers and Acquisitions industry comes to a screeching halt when there is a bust.

It is almost naive to expect anything different, in such circumstances, as companies just do not see the benefits. Thus leading to very slow valuations.  

The M&A industry is further hampered by the fact that the availability of financing is an issue, to fund acquisitions, or the requisite funds required to make mergers smooth. Logically, the availability of funds and tax breaks can encourage the industry to get into a flurry of activity again and boost the economy. In some cases, this works, in others in fails, as again the availability of credit is seen as, to a certain extent easy, leading to bad valuations. Clearly, the various government-led economic stimulus plans initiated in the last few years demonstrates this.
Thus valuations benefit in a buyer’s market and don’t do so in a seller’s market.

Given this scenario, what does the future hold for us? Are business valuations set to improve? Probably not. Because investments have come to a standstill, almost every investor is choosing the wait and watch approach.  The soft market conditions, characterised by slow growth, high interest rates and inflationary conditions lead to investors having very low confidence levels in the present circumstances and the future. Thus despite the availability of low-cost investment opportunities, the lack of a clearer view on when their pay-off period will come, has lead to poor investment. This will probably also lead to changes in the M&A industry trends. All this pointing to the fact that business valuations are not set to improve anytime soon.

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