All companies are influenced (more or less) by the market, and as the saying goes, “A rising tide lifts all boats.” Well, the tide was out in 2022, with headline-making inflation and rising interest rates roiling the market. Fortunately for ESOP companies, January 1 not only kicks off the calendar-year administrative cycle, but also presents an opportunity to start fresh and improve upon last year’s results.
As an ESOP-owned company, in addition to routine considerations such as reviewing the plan document, closing the books, preparing forecasts, and retaining trustees and valuation advisors, you can expect to face special opportunities and challenges as you move forward after the market volatility of 2022. Understanding how market conditions are changing in 2023 will allow for smooth(er) sailing as you establish forecasts, prepare for valuations, and invest capital.
In this article, we have distilled last year’s economic results and provided a year-end snapshot—as well as a Financial Market Pocket Guide which lists important market valuation inputs as of December 31, 2021, and December 31, 2022—to help you begin 2023 with your sails up and successfully continue on your ESOP journey.
Persistent inflation made 2022 a difficult year for financial markets, and the Federal Reserve raised the target federal funds rate dramatically. In addition, the war in Ukraine and China’s zero-tolerance COVID-19 policy impacted supply chains and weighed down markets.
Impact on ESOP companies. General market factors will inhibit company stock value. Interest rates and market multiples have trended toward long-term historical averages, which may provide opportunities for buyers in the near term.
The impact of inflation. Inflation captured headlines throughout 2022, and it remains a pressing issue today. In 2022, inflation in the U.S. reached its highest levels since the early 1980s.The Federal Reserve got serious about tackling inflation by increasing the target federal funds rate from 0.25 percent to 4.50 percent during the year. The graph below details the change in the consumer price index (CPI) and the target federal funds rate since 2018.
Investing (and forecasting) in an inflationary environment requires knowledge of the relationships between prevailing interest rates, nominal growth rates, and inflation. When inflation exceeds expectations, markets suffer—which is exactly what happened in 2022.
The good news for 2023 is market participants (and the Federal Reserve) have had a year to respond to elevated levels of inflation, and inflation has decreased since June.
Even though inflation was higher throughout 2022 than in 2021, expected inflation as of December 2022 was at-or-below expected inflation levels in December 2021:
The November 2021 and 2022 University of Michigan Consumer Sentiment Index both forecasted inflation for the next 12 months of 4.9 percent.
Expected inflation over longer-term periods is lower than it was in December 2021 (see the table below, which shows the five-year inflation expectations over the period from December 31, 2017, to December 31, 2022.
Financial forecasts are often prepared on a nominal basis. Nominal forecasts should reflect inflation expectations—however, certain line items will be more or less affected by inflation. Despite headline-grabbing inflation in 2022, forecasts should reflect expected inflation levels, which (as shown above) are more tempered. Pointing out how your forecast addresses these levels will help the ESOP trustee and valuation advisor assign the proper level of risk to your forecast and will prevent them from assigning a discount rate that is too high and potentially undervaluing your company.
Debt market performance. The value of bonds is inversely related to market interest rates. As shown in the graph below, short- and long-term interest rates increased throughout the year. The U.S. aggregate bond market, as measured by the iShares Core U.S. Aggregate Bond ETF (ticker: AGG), closed 2022 down 15.0 percent.
Debt market implications. Higher interest rates are resulting in greater debt service costs for corporations. SOFR, a benchmark interest rate for bank debt, increased from 0.05 percent to 4.30 percent during the year. Domestic corporate debt issuances were down 27.8 percent year-over-year through the third quarter of 2022.
While rates increased precipitously in 2022, context is key. Despite the increase in interest rates in 2022, the current rate on five-year Treasury securities1 of 3.99 percent is equal to the average rate since 1988 (as shown in the graph below)—only 10 basis points higher than the average rate from 2000 to 2009. In short, interest rates have increased from historical lows experienced since 2010 (and especially during the COVID pandemic) to historical averages.
From a valuation perspective, the cost of debt is a component of the weighted average cost of capital. All else being equal, an increase in the cost of debt will result in a lower valuation indication from the income approach method. Depending on the valuation, your company’s cost of borrowing or a market rate may be applied. The market rate on corporate debt with a Baa rating (a common proxy for cost of debt) increased from 3.37 percent at the end of 2021 to 5.84 percent at the end of 2022.
Equity market performance. In 2022 stock markets were down, with the S&P 500 and Russell 2000 indexes decreasing 19.4 percent and 21.6 percent, respectively. As shown in the graph below, the indexes peaked in the first week of the year, with the S&P 500 bottoming in mid-October and the Russell 2000 bottoming in mid-June.
M&A activity decreased in 2022, from record-high deal volume in 2021 to levels consistent with historical averages. Through July 2022, domestic deal volume and total deal value were approximately 30 percent lower than levels for the same period in 2021.2 Deal announcements also slowed in the third quarter of 2022.3 In 2022, the domestic IPO market decreased from a record year in 2021 to lows not seen since the peak of the Great Recession.4
Equity market implications. There was downward pressure on equity valuation metrics, with valuation multiples on the major indexes contracting during the year and required returns on equity increasing.
In general, valuation multiples decreased from December 31, 2021, to December 31, 2022, as evidenced by the contraction in the S&P 500 trailing 12-month (TTM) EBITDA multiple from 16.7x to 12.5x.
Required returns on equity investments increased with interest rates. The long-term risk-free rate (based on 20-year Treasury bonds) doubled over the year, increasing from 1.94 percent to 4.14 percent. Equity risk premiums also increased throughout the year.5
Looking Ahead: Planning for 2023
In terms of capital structure optimization, the change in interest rates presents opportunities and challenges for ESOP companies. Now is a good time to review and revise your company’s approach to cash, debt, and investment decisions. Here are a handful of considerations:
Placing a lower priority on paying down existing fixed debt facilities
Hedging against interest rate changes
Requiring greater returns on investments financed with debt
Ensure forecasts reflect current borrowing costs
Repurchase obligation considerations
Review your plan document and determine whether lump-sum payments or installment payments are beneficial to the company
Evaluate whether it is a good time to purchase any overhang from departed participants
Performance in a downturn. Given the state of the market, banks, investors, and valuation advisors will want to understand how your company expects to perform during an economic downturn, should one occur. You should be prepared to address questions related to your company’s capital availability, ability to improve cash flow, and relationships with banks.
What is the “new normal”? Since the onset of COVID, normalization adjustments have been in flux. At this stage, your company should have greater visibility into “normal” expenses. Normal expenses should reflect your expectations going forward and are likely to include some of the expenses initially considered “one-time” during the onset of the pandemic.
Wage inflation. For ESOP companies, a silver lining of inflation is growth in compensation will increase the allowable deductible ESOP contribution expense, which will allow you to reduce taxable income.
Preparing for negative market effects on share value. Many ESOP companies will have negative share price performance as of December 31, 2022, due solely to market effects. General market factors used for valuation negatively impact share value. Communicating your company’s share value and the market’s impact on share value will be important to continue to motivate your ESOP participants.
The five-year Treasury was selected because five years is a typical period for corporate term debt.
The 2022 M&A Report, Boston Consulting Group, October 20, 2022
Pitchbook Global M&A Report, Q3 2022
EY Global IPO Trends 2022.
For instance, the recommended Kroll equity risk premium and the equity risk premium estimated by Professor Aswath Damodaran increased during 2022. The equity risk premium databases that rely on annual data have not been updated for 2022 results.