Rates, risks and your pharmacy’s value: Part 1

The U.S. Federal Reserve and the Bank of Canada have declared war on inflation, and they have launched a series of monetary policy salvos in the form of unprecedented interest rate hikes. And that war likely isn’t over yet. Central banks have been raising rates at the fastest pace since the early 1990s, and it has shaken up valuations everywhere. All asset classes continue to reprice to reflect the increasing cost of money needed to buy just about everything.

It is a law of financial gravity: increasing borrowing costs increase risk. Think about that for a second. If you borrow money to buy an asset at 1.5% and its value goes down by, say, 0.5% in a year, you would be out 2% – a risk, certainly, but not a huge one. If, however, you borrow at 6.5% and the asset’s value goes down by the same 0.5%, then you are out 7%. That’s quite a difference. And there really is no place to hide in this rising-rate environment: the increased risk applies across the spectrum of asset classes. Higher interest rates adversely impact the valuation of homes, commercial real estate, bonds, equities and – most important for our purposes here – businesses, including pharmacies.

Clearly, would-be pharmacist-owners are finding that the days of cheap borrowing costs are waning. So, are existing pharmacist-owners in the process of refinancing as the terms on their mortgages come due? So far, any slump in valuations and transaction activity has not nearly reached the depths of the 2008-2009 Great Financial Crisis, but much depends on how far central bankers are willing to push rates in their fight against inflation. While they attempt to thread the needle between cooling down inflation and tipping the economy into a recession, monetary policymakers have made it clear that they are willing to further sacrifice asset prices to achieve their goal.

For pharmacist-owners considering selling their business – or for any owners looking to maximize the value of their pharmacies generally, as every owner should be – it might be tempting to simply throw up one’s hands and curse the policy powers-that-be. Yet our view is that pharmacist-owners can and should do more than simply surrender the value of their businesses to the fates. In fact, now is the time – perhaps more than ever – to pursue every means available to maintain and enhance their pharmacy’s value, even as rates are on the rise.

That process begins with understanding how risk factors into business valuation, and it ends with taking steps to mitigate those risks as much as possible. One simple and widely accepted method to value businesses is to divide recurring annual cash flow by risk rate (which is equal to the expected rate of return on the investment), usually expressed as a percentage. The higher the cash flow (the dividend, mathematically speaking) and the lower the risk rate (the divisor), the higher the value of the business (the quotient). With interest rates rising, a potential buyer’s cost of capital – the return needed to justify a capital expenditure – has gone up, raising the risk of any purchase. All else (like cash flow) being equal, that higher risk rate lowers the market value of a business asset.

What might a pharmacist-owner do to counteract that? In large part, it comes down to lowering the risk in the business. In our next article, we’ll do a deeper dive on the risks to look for, their impact on company valuations, and ways to try and mitigate them.