• Boom and Bust: The Role of Business Valuation in the Recent Financial Crisis

    pdficon2David J. Rapp
    Saarland University
    Email: rapp@iwp.uni-saarland.de

    Recently, we observed one of the greatest economic downturns in history, i.e., the financial crisis and its effects. Even though capitalism is often blamed for causing this crisis, it must rather be characterized as a crisis of socialism. Financial crisis‘s breeding ground is the centrally planned low interest rate policy of central banks in the aftermath of the “dotcom bubble”, because it distorted the free market for interest rates and, hence, caused a typical boom and bust cycle by misleading investors into malinvestments (e.g., Woods 2009). Since investors base their investment decisions upon business valuations (e.g., Hering 2014), it is crucial to analyze how a low interest rate policy influences business valuation and how business valuation contributed to the recent financial crisis.

    Low interest rate policy’s impact on business valuation

    The two most popular approaches to business valuation, which investors apply in preparation of their decisions, are the income approach on the one hand and the market approach on the other hand. The former appraises a certain business by discounting its expected future benefits, whereas the latter tries to deduce business values directly from observable (market) prices.

    Since the income approach is based upon the widely recognized present value tech­nique, a low interest rate policy may potentially influence either of the two crucial in­put parameters, i.e., the discount rate or the future benefits, and possibly even both. Since the discount rate reflects a certain interest rate, obviously the discount rate at least might be affected by central banks’ interest rate policy. Generally, a lower discount rate (based upon the cur­rent interest rate level) leads to higher business values and, hence, (market) prices paid.[1] This conclusion can be simply drawn from the financial-mathematics based relations within the income approach.

    The income approach is found in the currently prevalent discounted cash flow methods (DCF). Usually, these methods rely upon models from neoclassical finance theory for the assessment of the discount rate, especially the capital asset pricing model (CAPM) for the measurement of the cost of equity (Koller, Goedhart, and Wessels 2010). Since the CAPM considers several factors (“risk-free” rate, expected return of the market portfolio, beta-factor) for the assessment of (parts of) the discount rate (e.g., Damodaran 2012), a lowering of the general interest rate level by central banks does not necessarily cause decreasing discount rates. A lowered “risk-free” rate may possibly be compensated for by either the expected market return or the beta-factor. However, usually the “risk-free” rate is estimated future-oriented, whereas the market return and the beta-factor are assessed using empirical observations, i.e., based upon historical data (e.g., Matschke and Brösel 2013). Hence, the “risk-free” rate already includes a recent interest rate level lowering, while the market return and the beta-factor still exclude the intended economic stimulus. Therefore, in most cases a low interest rate policy causes lower discount rates based upon the CAPM. In addition, in the most popular DCF variant, the weighted average cost of capital method (WACC), the discount rate also contains cost of debt (e.g., Brealey, Myers, and Allen 2013). Lending at lowered interest rates ceteris paribus causes an increasing debt ratio and finally a decreasing discount rate within the WACC. Therefore, the interest rate level lowering causes higher business values and, hence, an increasing price level.

    Basically, central banks intend to stimulate the economy with a decrease in the interest rate level by providing incentives to spend money (investments, consumption) rather than save it (e.g., Herbener 1999). For this reason, central banks’ low interest rate policy also impacts the estimation of future benefits within the DCF methods. The economy temporarily benefits from the artificial boom caused by central banks’ interest rate policy, which is reflected in increased turnover and higher net income. Since appraisement practitioners usually use current or frequent benefits for a simple extrapolation, they tend to overestimate a business’s future benefits in low interest rate periods. Unfortunately, most appraisers are not aware of the Austrian business cycle theory (ABCT);[2] they are, therefore, misled by the artificial boom caused by the central banks’ low interest rate policy. As a result, business values and, therefore, prices paid increase in response to an interest rate level lowering.

    As can be seen, central banks’ decision to lower the interest rate level heavily impacts both the discount rate and the estimation of future benefits within the prevalent DCF methods. Even though the discount rate does not necessarily decrease in response to lowered interest rates, in the aggregate, business values increase as a result of lowered interest rates and finally cause rising (market) prices. Therefore, central banks’ low interest rate policy leads to an upward spiral that misleads investors into malinvestments which are only seemingly profitable.

    In contrast to the income approach, the market approach does not appraise a business by discounting its future benefits; instead, the basic idea of the market approach is to deduce business values from observable (market) prices (e.g., Olbrich 2000). If the business under consideration is listed at a stock exchange, according to the market approach the appraised business value equals the price for a single stock multiplied by the amount of stocks issued (plus a control premium). If the business to be analyzed is not listed, the business value is deduced from either “comparable” companies’ stock prices or the price which has recently been paid for a “comparable” company as a whole.

    Usually, stock markets benefit from central banks’ decision to lower the interest rate level (Kelly 2010). Cheap money is available in the market and it is used – at least in parts – to invest in stocks. Therefore, the market prices of stocks increase on average due to the rising demand. Since the market approach tries to directly deduce business values from (market) prices, an increased price level automatically leads to increasing business values. Therefore, a low interest rate policy causes a circular flow. Increasing prices lead to higher business values which lead to further rising prices; consequently, malinvestments are inescapable.

    Mainstream’s misconception

    The various DCF methods are undoubtedly the most popular business valuation methods of our time (e.g., Brösel and Hauttmann 2007). However, they aim to calculate a single objective market value for goods and, therefore, neglect the subjectivity of value. Since such an objective market value does not exist in the real world, DCF methods usually (have to) rely upon models known from neoclassical finance theory, especially the CAPM as well as Modigliani’s and Miller’s irrelevance proposition (MM), for the assessment of the required discount rate (e.g., Matschke and Brösel 2013). Both MM and CAPM are based upon several highly restrictive assumptions, which particularly contain an assumed perfect capital market that is characterized by a single secure market interest rate i for both lending and investing, an unlimited access to lending, information symmetry and the absence of taxes and transaction costs (e.g., Hering 2008, Hering 2014). In addition, the CAPM also requires the assumptions of market participants’ homogeneous expectations and risk aversion (e.g., Hering 2008). As a result, MM and CAPM and, hence, DCF methods assume an artificial and escapist world (e.g., Rapp 2014a).

    Since DCF methods deny the subjectivity of value, they do not consider the actual crucial individual factors, especially subjective ends and means (financial opportunities); instead, current DCF methods primarily focus on “objective” capital market data (Hering 2014). Therefore, market developments remarkably influence the appraisement calculus. Finally, the strict market orientation leads to an upward spiral in the forefront of the crisis and in a race to the bottom once the market turns. As DCF methods deny the subjective nature of value, usually rely upon unrealistic assumptions, and require a strict market orientation, they mislead real-world investors into misallocations (e.g., Olbrich et al 2015).

    Comparable to the neoclassical DCF methods, the common market approach aims at the assessment of a single objective market value for goods. Hence, the market ap­proach neglects the subjectivity of value, too (Olbrich 2000). In contrast to the DCF methods, the market value is deduced from observable (market) prices. Therefore, the market approach misunderstands the basic relation between (business) values and prices, since (business) values cause prices, but prices do not cause (business) values (e.g., Rapp 2014b). As a consequence of this fundamental misunderstanding, the market approach misleads investors into malinvestments. Again, the strict market orientation leads to an upward spiral in the forefront of the crisis and to a downward spiral once the market turns.

    Austrian alternative

    Obviously, there is a necessity for a proper alternative to the current mainstream in business valuation. First of all, one needs to recognize that business valuation must respect and consider the subjectivity of value in order to really support entrepreneurs in their real-world investment decisions (e.g., Matschke, Brösel, and Matschke 2010, Herbener and Rapp 2014, Olbrich et al 2015). Fortunately, a subjective approach to business valuation, which meets this criterion, has been developed by German-speaking authors over the past more than a century and a half. These authors traditionally refer to the marginal utility concept and early Austrian economists, especially Carl Menger (e.g., Liebermann 1923, Schmalenbach 1937, Brösel, Matschke, and Olbrich 2012, Matschke and Brösel 2013, Hering 2014, Olbrich 2014 and Rapp 2014a). Since Menger can be characterized as the founder of Austrian economics, subjective business valuation theory and Austrian economics are blood brothers in fact. Mises explicitly recognized the implementation of subjectivism into the early German business management theory by emphasizing the works of Eugen Schmalenbach (Mises 1933 [2003]), who was one of the most crucial driving forces for the development of the German business management theory, in particular accounting theory and subjective business valuation theory.

    The subjective business valuation theory illustrates how the subjective nature of value can be reflected in business valuation. Following this concept, the income approach can be used for the purpose of a subjective business valuation, if applied in the shape of the future earnings method (FEM) (e.g., Olbrich et al 2015). In contrast to the currently prevalent DCF methods, the subjective FEM needs to contain strictly individualistic input parameters. Therefore, the income approach’s numerator must consider the future payment flows which a specific deciding person expects to gain from the business under consideration, including personal tax rates and potential tax loss carry forwards, individual synergy effects, the possibility to influence the company’s corporate policy, personal future expectations as well as the individual’s appetite for risk (e.g., Olbrich et al 2015).

    In contrast to the popular DCF methods, the denominator, which serves as a standard of comparison for the business being appraised, should not incorporate a patchwork of different and – with regard to underlying assumptions – incompatible neoclassical models (MM, CAPM), since they deny the subjectivity of value and require escapist assumptions in order to deduce a (pseudo-)“objective” standard of comparison. Instead, the subjective FEM concept necessitates the consideration of the deciding person’s individual optimal marginal use of money which is determined by this person’s (financial) ends and alternatively available means, i.e., alternative investment and funding opportunities (e.g., Olbrich et al 2015). The individual marginal utility of an additional dollar is determined by the internal rate of return of a certain individual’s marginal object, i.e., the internal rate of return of the last funded or invested dollar in this person’s overall investment and funding program (e.g., Hering 2008). The crucial marginal object either accords with the least profitable investment opportunity or the most expensive funding alternative which is ranked and chosen by the deciding individual in order to reach his personal ends. For person A, who is partly funded with debt capital, the best alternative action to purchasing a certain business might be to pay back the most expensive loan (at least in parts), whereas for person B, who is not at all indebted, another investment alternative is the best available action compared to the purchase of the business under consideration. Therefore, person A and person B need to consider their actual best alternative action’s corresponding internal rate of return as their subjectively correct personal standard of comparison.

    Following FEM’s requirements pointed out in this section, business valuation can avoid the current mainstream’s misconceptions and, hence, does not mislead real-world investors into misallocations. However, the subjective application of the income approach may also be – at least partly – influenced by a low interest rate policy, since such a policy can have an impact on the individual investment and financing opportunities. If central banks’ low interest rate policy actually affects a certain individual’s marginal object, even the subjective business valuation concept will result in a distorted business valuation for this specific person. But it is not and it cannot be business valuation‘s responsibility to eradicate a socialist interest rate policy. As long as there will be central banks, every business valuation – (pseudo-)objectively or subjectively applied – may be distorted. Fortunately, the subjective, Austrian concept of business valuation can be combined with the findings of ABCT. Consequently, the estimation of future payment flows should consider the development of central banks’ artificially created boom and bust cycles (Herbener and Rapp 2014). Thereby, appraisement practitioners can avoid overestimations of future benefits in low interest rate periods and, hence, being misled by central banks’ market distortions. Therefore, the subjective concept of business valuation can at least limit low interest rate policy’s negative effects and – unlike the neoclassical DCF methods as well as the market approach – does not support central banks in misleading real-world investors into disadvantageous investments.

    Four main conclusions

    Four main conclusions can be drawn from the above presented:

    Central banks’ low interest rate policy has a heavy impact on the two most popular business valuation approaches and basically leads to higher business values which result in only seemingly profitable investments.

    Both the popular neoclassical DCF methods as well as the market approach to busi­ness valuation include misconceptions that finally mislead investors into misalloca­tions. The required strict market orientation causes an upward spiral in booms and a race to the bottom in busts.

    A proper alternative can be found in the mature subjective business valuation theory which is inspired by early Austrian economics.

    Even the subjective concept is not able to finally solve the problem of central banks’ market interventions; however, at least it can limit its effects.


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    [1] For an exception to this general rule see Hering (2008).

    [2] For the fundamentals of ABCT see e.g. Rothbard (2009).