High inflation in Poland and around the world affects many areas of economic life. Such examples may be the rising costs of debt of individual governments - a function of the higher yield on government bonds required by investors, or declines on stock markets reflecting the increasing cost of capital resulting from increased macroeconomic risk.

The table below presents a summary of inflation rates (measured in HICP - Harmonized Indices of Consumer Prices) in the period 2016 - September 2022 for Poland, 27 European Union countries and the USA. Inflation data shows the change in a given month year-on-year.

		12M16			12M17			12M18			12M19			12M20			6M21			12M21			3M22			6M22			9M22
Poland		0.9			1.7			0.9			3.0			3.4			4.1			8.0			10.2			14.2			15.7
EU27		1.1			1.4			1.6			1.6			0.2			2.2			5.3			7.8			9.6			10.9
deer		1.5			1.8			1.5			2.0			1.1			6.4			8.1			9.2			b.d.			b.d.

 Source: https://ec.europa.eu/eurostat/web/hicp/data/database

The table below shows the yield levels of 10-year bonds for Poland and the USA (the data shows the latest transaction data in the period). 

		12M16			12M17			12M18			12M19			12M20			6M21			12M21			3M22			6M22			9M22			10M22
Poland		2.79%			3.18%			3.30%			2.03%			1.35%			1.56%			3.00%			5.22%			6.92%			6.79%			8.52%
USA*		2.44%			2.34%			2.87%			1.80%			0.90%			1.44%			1.45%			1.84%			2.95%			3.24%			3.85%

Sources from:  https://www.treasurydirect.gov/auctions/announcements-data-results/announcement-results-press-releases/treasury-marketable/ https://www.gov.pl/web/finanse/bony-i -wholesale-bonds1

The table below shows changes in stock indices for the Polish, US and German stock exchanges. Data from individual months (for example, 6M means June) show the average opening price for the days of the month.

		12M16				12M17				12M18				12M19				12M20				6M21				12M21				3M22				6M22				9M22
WIG		48,696				62,684				58,933				57,644				53,042				66,407				68,572				61,479				57,485				49,679
change index		-				129%				94%				98%				92%				125%				103%				90%				94%				86%
S&P 500		2,200				2,645				2,791				3,144				3,646				4,217				4,603				4,363				4,150				3,937
change index		-				120%				105%				113%				116%				116%				109%				95%				95%				95%
DAX		10,593				13,044				11,535				13,265				13,372				15,513				15,233				14,404				14,478				12,714
change index		-				123%				88%				115%				101%				116%				98%				95%				101%				88%

Source : https://stooq.com/

It is obvious that the high level of inflation also affects the process of valuing enterprises and companies. Let's analyze the main hot areas of business and company valuations regarding increased inflation:

• valuation date,

• valuation report,

• usefulness and timeliness of the valuation,

• valuation approaches and methods.

Valuation date

The valuation date - i.e. what day the valuation is carried out - is crucial in the valuation process. The valuation process should take into account all information, facts and events objectively existing at the valuation date plus future events that can reasonably be predicted at the valuation date. In English, two combined terms are used to refer to this information, facts and events - "known and knowable".

The valuation date is not the same as the date of preparation of the valuation report - the date of completion of work on the valuation by a given specialist and sending the report to the client. Theoretically, the date of preparation of the report should not affect the recommendation of the valuation value.

Moving on to more practical ground, in the case of valuations of Polish enterprises and companies, it should be assumed that the following levels of inflation (HICP) should be taken into account by the valuer for individual valuation dates:

• December 31, 2020 – 3.4%

• June 30, 2021 – 4.1%

• December 31, 2021 – 8.0%

• March 31, 2022 – 10.2%

• June 30, 2022 – 14.2%

• September 30, 2022 – 15.7%

Specifically, this means that when adopting a specific valuation date, the inflation level on a given date and the inflation expectations existing on a given date should be taken into account. It should be emphasized that each valuation process should be analyzed separately - the general level of inflation as at the valuation date should be analyzed in the context of the specific market situation of the valued entity, and in particular its relations with customers and suppliers as at the valuation date.

Valuation report

Taking into account the significant impact of inflation on the economic situation of the valued business entity and its fair value (or fair market value), the appraiser should consider including an appropriate clause/disclaimer in the valuation report explaining how the valuation process takes into account and/or takes into account the increased level of inflation. . This type of additional clause should assist users of the valuation report in properly understanding the results of the work and should reduce the risk of misinterpreting value recommendations.

It is worth noting that when the valuation date is before the period of increased inflation (retrospective date - i.e. in Polish conditions before the end of 2020), there is generally no obligation to include a reservation regarding the increased level of inflation in the report (the exception would be a situation where at the valuation date there were strong inflation expectations despite its low actual level). The reason is simple - if high inflation could not be assumed at the valuation date, then the issue of inflation does not exist from the point of view of the valuation process at an earlier date. An alternative solution is to present a reservation in the valuation report regarding the level of inflation as at the valuation date in the context of its increased level as at the date of preparation of the report, or to prepare a separate letter to the client explaining the treatment of inflation in the valuation.

In general, inflation issues should be considered analogously to the recognition of events after the balance sheet date when preparing financial statements - events after the balance sheet date (in accordance with point 6.1 of the National Accounting Standard No. 7 "Changes in accounting principles/policy, estimated values, correction of errors, events occurring after balance sheet - recognition and presentation"), may:

• a) provide new information about circumstances existing at the balance sheet date, or

• b) indicate circumstances that occurred after the balance sheet date.

The events referred to in point a) "have retroactive effect" - that is, they are taken into account when preparing financial statements and accordingly affect the items of the profit and loss account and the balance sheet. Events that meet criteria b), with the additional assumption of significant significance for the recipients of the financial statements, require an appropriate explanation to be included in the notes to the financial statements (they do not adjust the items of the profit and loss account and the balance sheet).

The usefulness and timeliness of the valuation

Assuming that the valuation was carried out on a valuation date preceding the onset of rising inflation, and the valuation report was prepared at a later date, the question arises to what extent such a valuation is useful and/or valid. 

If the valuation was carried out for the purpose of preparing the financial statements and balance sheet as at December 31, 2021, the valuation is useful (the recommended value in the valuation report can be appropriately included in the prepared financial statements for the financial year ending December 31, 2021), but , taking into account the strong increase in the inflation rate in 2022, not necessarily current as of the date of presentation of the valuation report.

The concept of usefulness is relative - from the point of view of the CFO / financial director responsible for preparing the annual financial statements, the valuation is useful - for use in the financial statements; from the point of view of a shareholder who received the financial statements for 2021 at the beginning of June 2022, information about the value of the financial asset valued as at December 31, 2021 may be of questionable usefulness. 

If the valuation was prepared for the purpose of advising on a contemplated acquisition of another entity, it should reasonably be assumed that the usefulness and validity of the prepared valuation for significantly past valuation dates are questionable. In such a situation, assuming the transaction purposes of the valuation, it is advisable to update the valuation to a more current valuation date. An updated valuation may present a value recommendation at a significantly different level than the original valuation - this does not mean that the original valuation was carried out incorrectly. Simply put, between the date of the first valuation and the date of the second, updated valuation, an event occurred that the valuator could not reasonably have predicted and, additionally, could have significantly influenced the economic situation of the entity and its value.

The macroeconomic situation and the economic situation in individual sectors of the economy are changing dynamically - this means that the valuation carried out on today's valuation date - November 22, 2022 (i.e. an openly "inflation" date) may differ significantly from the valuation carried out 10 months ago (e.g. with a valuation date of December 31, 2021). The uncertainty and variability of the macroeconomic situation may result in the fact that the sets of information, facts and events that objectively exist on two different "inflation" dates (plus future events that can reasonably be predicted on these two valuation dates) do not have to coincide - this means that there is no single "inflationary" state.

Valuation approaches and methods

When carrying out a valuation in times of high inflation, the valuer should carefully consider how the existing specific situation may affect the scope of data and assumptions standardly used in valuation approaches and methods. Let us divide our considerations into three main approaches to the valuation of companies and enterprises.

In the asset (cost) approach, it is advisable for the appraiser to consider carrying out:

• valuation (valuation update) of real estate on a date consistent with the valuation date; please note that in accordance with the provisions of the Real Estate Management Act, an appraisal report may be used for the purpose for which it was prepared for a period of 12 months from the date of its preparation, unless there are changes in legal conditions or significant changes in factors such as the purpose of the valuation, type and location of the property, intended use in the local plan, condition of the property, as well as available data on prices, income and characteristics of similar properties; obviously, increased inflation may constitute a significant change in the available data on real estate prices, which means that even, for example, a valuation carried out 6 months earlier may become outdated;

• review and valuation of the most important items of machinery and equipment, the value of which may have changed significantly in times of inflation;

• reviewing the economic situation of entities whose shares/shares the valued entity holds and making an up-to-date valuation of the shares/shares held;

• reviewing the economic situation of customers and creating appropriate provisions for trade receivables;

• valuation of debt financial instruments (credits/loans/bonds) contracted/issued and granted/purchased with a fixed interest rate, together with an assessment of the economic situation of entities - debtors;

• valuation of intangible assets (in particular those typically valued using income methods and not usually disclosed in financial statements - e.g. trademarks and customer relations) based on "inflation" assumptions.

Under the income approach, it is prudent for the valuer to consider:

• valuation of non-operating assets and debt (credits, loans, bonds, lease liabilities, etc.);

• undertaking an analysis regarding the consistent adoption of the forecast in fixed (real) prices or variable (nominal) prices;

• use, in the case of a forecast at constant prices, the cost of capital in real terms,
  i.e. 1 + WACC_nominal = (1 + inflation) x (1 + WACC_real )

• analysis of the forecast issue at constant (real) prices related to forecasting the net value of fixed assets and depreciation;

• for forecasts at variable (nominal) prices, preparation of forecasts/projections/financial plans taking into account appropriate inflation paths for individual groups of revenues and individual categories of costs related to:
  • 1. prices of products and services sold (relations with customers and contracts with them) and purchased (relations with suppliers and contracts with them);
  • 2. employment;

• for the forecast at variable prices, preparation of a scenario analysis (several scenarios) for EBIT/EBITDA based on various assumptions of the impact of inflation factors on the future market/economic situation of the valued entity (mainly in the context of various possible inflation paths for individual income groups and cost categories) and preparation analysis of the EBIT/EBITDA margin enabling the assessment of the extent to which it is "resistant" to inflation shocks;

• for the forecast at variable prices, estimating the nominal level of the cost of capital for individual years of the forecast and for the residual period, with particular emphasis on aspects such as:
  • 1. specific risk should be related to the specific situation of the entity being valued;
  • 2. the variable/changing cost of capital in the forecast period should be consistent with the adopted inflation path - the variable cost of capital is a consequence of the changing cost of equity capital and the cost of debt, which are a consequence of inflation changes;
  • 3. the forecast period should be long enough to assume that pre-inflation conditions are appropriate after the forecast period (for the residual period);

• application of the DCF method and/or cash flow capitalization method; the cash flow capitalization method by default assumes a constant level of the cost of capital, which, given the assumption of a changing inflation rate and, consequently, a variable cost of capital, makes the application of this method highly questionable;

• preparing forecasts/projections for individual working capital items and for investment outlays, consistent with the adopted assumptions for revenues and costs, consistently at variable (nominal) or fixed (real) prices.

Comparative (market) approach – it is advisable for the appraiser to consider the following issues:

• multipliers based on the capitalization of public companies as of the "inflation" date and data from pre-inflation financial statements may not be appropriate for valuation as of the "inflation" date; the valuer should consider actions (attempts) to ensure that multipliers are consistently based on "inflation" data or, alternatively, that pre-inflation multipliers are appropriately adjusted;

• in relation to comparable public companies, the valuer should take into account the fact that the longer the period between the balance sheet date and the valuation date, the greater the probability that the share price (capitalization) is shaped to a lesser extent by the financial data included in the annual financial statements and to a greater extent by events after the balance sheet date; consequently, it is advisable to analyze the economic situation for individual comparable entities from the last balance sheet date of the annual financial statements to the valuation date, including the analysis of periodic financial statements after the balance sheet date of the annual financial statements (quarterly and half-yearly reports);

• with regard to multipliers based on private transactions (non-public markets) from the pre-inflation period, it is advisable to consider making appropriate adjustments to pre-inflation multipliers reflecting the increase in risk and cost of capital;

• with regard to multipliers based on private transactions (non-public markets) from the "inflationary" period, it is advisable to make sure that transaction prices can constitute the basis for estimating fair market value - in particular, whether the selling party was not forced to sell due to the risk of threat loss of liquidity.

Of course, apart from the issues mentioned above, there may also be other specific issues in the valuation of a given enterprise or company related to a high level of inflation - the only possible reasonable suggestion is to carry out the valuation with "eyes wide open" - that is, with sensitivity to inflation-related issues affecting value creation.

Let's hope that the high level of inflation will end soon and we will return to the blissful times of inflation at the level of 1%-1.5%. To what extent my hope is based on rational premises and to what extent it is a manifestation of wishful thinking, I leave to you to consider.