Following President Trump’s return to the White House, the shifting trade policy landscape has left many business owners reeling. The sudden implementation of tariffs has sent ripples through supply chains, pricing structures, business inventories, and consumer spending patterns. Amid this turbulence, one question stands out: How do trade wars impact my company’s valuation?
Classifying & Quantifying Risk in Valuation
Before we discuss the impact of tariffs, it is important to brush up on how valuation appraisers classify risk and how risk is quantified. Risk is generally classified as:
- Systematic Risk: These are unavoidable macroeconomic factors that impact all companies, such as market downturns or interest rate fluctuations.
- Unsystematic Risk: These are company-specific risks, including legal issues, loss of key personnel, or customer concentration.
Valuation appraisers utilize discount rates when quantifying risk, such as the cost of equity. The cost of equity is commonly broken into key components:
- Risk-Free Rate (RFR): The baseline return for a risk-free investment, typically benchmarked to U.S. Treasury bonds.
- Equity Risk Premium (ERP): The extra return investors expect for taking on the volatility of the stock market.
- Beta: A measure of a company’s sensitivity to overall market movements. A beta above 1 signals higher volatility.
- Size Premium: Smaller companies carry more perceived risk, justifying an additional premium.
- Company-Specific Risk Premium (CSRP): This captures risks unique to a business, such as dependency on key customers or outsized exposure to geopolitical events like tariffs.
Of note, risk can also be captured by lowering forecast cash flows. However, for this example, we will exclusively focus on the impact of discount rates.
Where Do Tariffs Fit In?
Systematic risks are largely reflected in the market rates (RFR, ERP, and beta). These capture broad economic shifts, including the residual effects of tariffs on global markets. However, not all tariff-related risks are created equal.
For companies disproportionately reliant on tariffed goods or global supply chains, the standard market rates fall short. A steel product manufacturer, for example, faces greater volatility than a local services firm unaffected by import costs. This is where the CSRP plays a pivotal role.
Adjusting for Tariff Exposure
Valuation professionals must assess the extent of a company’s exposure to tariffs. Questions to consider include:
- How much of the company’s supply chain is reliant on tariffed goods?
- Can the company pass increased costs to consumers, or will margins suffer?
- Is the exposure short-term or indicative of a long-term vulnerability?
The more a company depends on tariffed goods, the greater the potential upward adjustment to the CSRP. This ensures the valuation reflects the real-world risks not captured by market rates.
The Seesaw Effect: Valuations in Flux
Just like tariff policies, valuations are not static. As trade policies shift, so too must the discount rates applied to future cash flows. As valuation professionals, we remain vigilant and continually adjust company-specific risk premiums to reflect the latest geopolitical realities.
In a world where trade policies can change overnight, valuations must remain flexible. For companies affected by tariff volatility, it is crucial to ensure that risk adjustments appropriately reflect reality, providing business owners with a clear understanding of their company’s true value.
