Valuation shapes a company’s financial future. For public firms, market cap reflects investor optimism. For private firms, cash flow analysis and WACC decide worth. This article explores how valuations impact debt/equity costs, why Tesla’s stock fell 50% amid slowing sales, and how economic cycles reshape pricing strategies.

Public Valuation: Market Multiples and Investor Sentiment

Public firms are valued using market capitalisation (share price × shares). Investors rely on multiples like P/E (price-to-earnings) to gauge growth potential. The PE is calculated by dividing the company’s total earnings by its number of issued shares. This is then divided by the current share price to give us the price-to-earnings ratio per share. For more information on this search for our article on why PEs vary.

Example:
Tesla once traded at a P/E of 250 times earnings, pricing in dominance of EVs. But with sales down 70% in Germany (2023), and many other countries, earnings expectations crashed. Its P/E has crashed, wiping billions from its market capitalisation (market value).

Why Higher Valuations Reduce Capital Costs:

Higher valuations signal financial strength and growth potential, lowering perceived risk for lenders and investors. For debt financing, banks offer better interest rates to highly valued firms, as their assets and cash flows provide greater collateral security. For equity financing, a premium valuation attracts investors willing to accept lower returns, reducing the cost of equity. This dual advantage allows companies to raise capital more cheaply, fueling expansion, innovation, and competitive edge.

• Lower Debt Costs: Banks offer better rates to highly valued firms (lower risk perception).
• Cheaper Equity: Issuing new shares at high prices dilutes ownership less.

Valuation Strategy Tip: Avoid being “priced to perfection.” Overhyped valuations crumble if growth stalls.

How Private Companies Are Valued: Cash, Costs, and Inflation

Private companies calculate their worth by predicting future profits and adjusting them to today’s value. Think of it like this:

• WACC: The average cost of funding (loans + investor returns). Higher WACC = bigger discount = lower valuation.

• Future Cash Flows: Money the company expects to earn in the future (e.g., $1M/year).

• Discounting: Because $1M promised in 5 years time isn’t worth $1M paid today (due to inflation and risk), we need to reduce it’s value. If you were offered $1M to be paid in 5 years time, how much would you reduce it to if it was paid to you immediately?

Key Factors:

1. Cash Flow Timing: Delayed revenue reduces present value (e.g., a startup waiting 3 years for profit).
2. Inflation and Economic Cycles:
   • Rising inflation hikes WACC, lowering valuation.
   • Recessions slash cash flow projections.
3. WACC Formula: WACC=(EV×Re)+(DV×Rd×(1−T))WACC=(VE​×Re​)+(VD​×Rd​×(1−T))
   E = Equity, D = Debt, V = Total Value, R_e = Cost of Equity, R_d = Cost of Debt, T = Tax Rate

Example:
A private SaaS firm with $2M in annual cash flow might be valued at $20M (10x multiple). If inflation rises 3%, WACC could jump from 12% to 15%, which would cut its value to $16M. As the future is unknown firms will use sensitivity analysis to determine a likely valuation range.

Key Valuation Factors

Valuing a company isn’t guesswork—it’s built on measurable elements. For private businesses, three factors dominate: cash flow (future profits), funding costs (what investors and lenders charge), and economic risks (like inflation). Together, these decide if a company is a hidden gem or overpriced. Let’s break them down.

1. Fundamental Analysis

• Income Statements: Compare revenue growth and margins. High depreciation? It may signal aging assets.
• Ratio Analysis: Debt/EBITDA > 4x? Riskier loans mean higher WACC.

2. Direct vs. Sequential Valuation

• Direct: Compare to public peers (e.g., a private e-commerce firm vs. Amazon).
• Sequential: Adjust for size and risk (e.g., a small logistics firm valued at half the industry multiple).

3. Shareholder Cost of Capital

Shareholders demand returns based on risk. If they expect 15% annually (vs. 8% for public firms), private valuations drop.

Why It Matters:
High return expectations inflate WACC, lowering valuation. Meeting targets reduces future capital costs. Even a profitable firm can be undervalued if risks are ignored. Get this right, and you’ll attract better deals.

Economic Cycles and Inflation: Reshaping Valuations

Valuations aren’t set in stone—they bend under economic pressures. Booms, recessions, and inflation act like tides, lifting or sinking a company’s worth. For example, during inflation, rising costs and interest rates shrink future cash flow value. In recessions, even strong firms may see valuations drop as buyers hesitate. Understanding these forces helps businesses prepare and adapt. Let’s explore how.

• Rising Inflation:
  • Increases WACC, lowering DCF valuations.
  • Example: A 2023 RBA rate hike could slash private valuations by 20%.
• Recessions:
  • Depresses cash flow projections.
  • Public firms see P/E multiples contract (e.g., some retail stocks in 2020 – during the COVID19 pandemic).
• Strategic Response:
  • Hedge against inflation with fixed-rate debt.
  • Build cash reserves for downturns.

Valuation Strategy: Why It Beats Guesswork

Guessing your company’s value is like navigating a storm without a compass—risky and unreliable. A valuation strategy replaces hunches with data, using tools like cash flow analysis, market comparisons, and risk assessments. For example, a tech startup might overvalue itself based on hype, only to crash when investors demand proof of profits. Strategy ensures you price accurately, attract fair deals, and avoid costly mistakes. Let’s dive into how to build one.

1. Avoid Overvaluation:
   • Tesla’s 2023 crash shows the cost of unmet expectations.
2. Optimise Capital Structure:
   • Use high valuations to refinance debt at lower rates.
3. Plan for Cycles:
   • Model best/worst-case scenarios for cash flows and WACC.

Case Study:
A biotech firm raised $50M in equity at a $500M valuation (pre-inflation). Post-rate hikes, its WACC rose, but the capital raised at peak valuation funded R&D, avoiding dilution. Ignoring economic shifts is like sailing blind. Navigate wisely, and you’ll avoid valuation pitfalls.

What’s Next?

Valuation errors can cost millions. Convergent Capital Corp connects you with experts to:

• Calculate precise WACC and DCF models.
• Strategise for IPOs or private sales.
• Navigate inflation and economic cycles.

🔗 Contact us today to unlock your firm’s true value.

Further Reading:

Internal Articles:

• Funding’s Gambit: Debt or Equity for Thy Venture
• The NPV Conundrum: A WACC-Driven Dilemma of Risk and Reward

External Resources:

• Reserve Bank of Australia – Research Discussion Paper – RDP 2024-10 – How Do Global Shocks Affect Australia?
• Reserve Bank of Australia Report: Why Are Investment Hurdle Rates So Sticky? December 2021