The impact of rising energy prices on company valuations

I. Rising energy prices in the wake of the Ukraine war

The second half of 2022 was strongly influenced by increasing inflation worldwide. According to the Federal Statistical Office of Germany (Statistisches Bundesamt), the inflation rate for 2022 in Germany totaled 6.9 %. Not only the German economy was strongly affected by rising price levels, but other economies are struggling with high inflation, too. One of inflation’s main drivers presents the sharp rise in energy prices.

The reasons are complex. On the one hand, the unrestrained global demand for energy is causing prices to increase – here, demand regularly exceeds supply. On the other, the political conditions regarding both the Ukraine war and climate protection are responsible for the current development in energy prices. According to the German Association of Energy and Water Industries (Bundesverband der Energie- und Wasserwirtschaft - BDEW), overcoming the COVID pandemic poses one of the energy price drivers. Recovering from the pandemic effects led to an increased energy demand all over the world. Furthermore, BDEW mentions low gas inventories due to the long winter in 2020/21, high electricity consumption as a result of a particularly hot summer in China and maintenance work on the Norwegian gas pipelines as reasons for the increase in prices. On the political scale, the war in Ukraine caused a further deterioration in gas supplies from Russia. The hope for recovery after the COVID pandemic was thus slowed down by the ongoing Russian war of aggression in Ukraine. Additionally, fossil fuels become more expensive based on EU's climate policy goals, as the issue of CO2 emissions is steadily gaining relevance with the CO2 tax and CO2 certificates.

Even though energy prices have been declining again since the beginning of 2023, a sustainable easing is not to be expected. According to the Federal Statistical Office of Germany, producer prices for energy in January 2023 were 32.9 % higher than in January 2022, despite the recent downward trend.

The last few months have shown that, depending on the degree of reliance on energy prices, companies are confronted with an acute need for action that will even endure into the future. A wait-and-see attitude until the situation on the energy markets eases again is considered inappropriate. The energy crisis reveals that particularly energy-intensive companies need to examine whether there is potential for energy savings, whether the existing business model in its current form is still sustainable or profitable at all, and what measures must be taken to be prepared for future energy crises.

Overall, the current energy crisis is not just a temporary ascend in energy prices leading to lower margins and surpluses. It can rather be assumed that companies will have to adapt entire business processes to some extent, analyze alternative business models and, above all, make investments. In other words, this energy crisis is leading to lasting changes in the cost and revenue structure of companies as well as a need for investment differing from the past.

Depending on how well companies succeed in overcoming the existing challenges posed by the energy crisis, this will have a lasting impact on the company’s own value.

II. The impact on company’s valuation

The company’s own value is regularly determined by the prospective distributable financial surpluses accruing to the shareholder. Therefore, future cash flows are to be valued in capital value-oriented valuation methods. Anything with a potential impact on future cash flows is relevant for valuation or influencing the company’s value.

Whilst energy prices are rising, at first, they cause ceteris paribus future cash flows to decrease. Overall, companies try to pass on the increased energy costs to their customers, however, to fully pass them on is usually not possible. Numerous companies are faced with the challenge of rising energy costs on the purchase side not being matched by price increases on the sales side. Therefore, the affected companies’ margins decline permanently. In extreme cases, especially energy-intensive companies are threatened with insolvency and production must be stopped, which in turn affects lastingly the future expected financial surpluses.

At this point, it would be far too short-sighted to simply adjust existing forecasts to the effect that margins will fall due to a temporary increase in energy prices and that, after a few years, planning can continue with the previous assumptions from before the energy crisis.

To create a decent planning for the next three to five business years, the company's development should be properly mapped and critically scrutinized by the valuer. Particularly the last three years have shown that companies are repeatedly confronted with market risks that cannot be explicitly planned.

The impact of increasing energy prices on companies and the action the company concerned should take due to the price rise depends, among other things, on which stage of the entire value chain said company is located. Oil companies, for example, have demonstrated that even with very high price increases it is possible to largely pass on the risen prices to the end customer. The decisive factor here poses the price elasticity of demand. Regardless the level of energy costs, many companies depend on a correspondingly high energy supply for their own production. In terms of energy, there are hardly any substitutes or “substitute products” that could be used as a fallback. The price elasticity of demand for energy is usually relatively low.

At the downstream stages of the value chain, the situation is far more individual. For instance, many energy providers cannot pass on the full extent of the increased purchase prices to their own customers due to contractually guaranteed prices.

Depending on the business model, rising energy prices have different impact. Therefore, the energy crisis impacts sooner or later are also reflected in the company’s cash flows according to the business model. Especially smaller businesses have run into difficulties due to the higher burden of rising energy prices on the purchase market. Not only gas and electricity bills, but also transport costs, among other things, reflect the energy prices’ impact.

Furthermore, many industrial companies face the problem of having to pre-finance their energy needs during production. The company's management should map the influence of rising energy prices on its own future cash flows within the framework of forecasts. In this context, solvency must already be checked and ensured in short-term.

Companies need to think at an early stage about the extent to which the future success of their own business depends on any further energy price rise and the extent to which such rise can be passed on to customers. Keeping in mind to assess the short-, medium- and long-term risks if the energy supply becomes a bottleneck. Furthermore, energy-intensive industries (but not only) ought to examine the possible use of alternative energy sources. In the case of an overall high dependency on energy prices and supply, necessary investments for a sustainable business model should be analyzed. Given any doubts, management concludes the current business model as no longer profitable whilst prices continue to rise, so that alternative business models must be sought.

In this respect, the current energy crisis can also pose a challenge for the entire business model. In general, the manufacturing industry in Germany is most affected by energy price rise. It is important to analyze individually how vulnerable the respective company is to further energy price changes in terms of profitability and business model.

Energy-intensive production, such as in the chemical or metal industry, is particularly affected by the energy crisis, being currently still dependent on traditional energy sources. As a result, the operation of the production facilities becomes more expensive due to the high energy costs, pushing up in turn the end products’ price.

Even though the energy crisis threatens the existence of most companies, there are also industries benefitting from it. Against the backdrop of increasing relevance of ESG criteria and sustainability, producers of renewable energies, for e.g., could profit, as the demand for renewable energies continues to rise in the context of climate protection and, especially as the Ukraine war demands for the greatest possible independence regarding the general energy supply.

It is obvious that the effects of rising energy prices will regularly have a negative impact on the valuation-relevant cash flows. As a result, rising energy prices weigh on corporate earnings and thus also on company values.

III. Conclusion

Overall, it should be noted that rising energy prices do not only lead to higher costs in the short or medium term, which in case of doubt are not offset by rising revenues. The current energy crisis also presents a situation with a possible lasting impact on future cash flows being particularly true for energy-intensive companies, whose profitability also crucially depends on a secure energy supply. It turns out that energy supply is not just a cost among many others, but that entire business models depend on it being calculable and secure. Any uncertainty in energy supply thus leads directly to valuation-relevant risks for the company in question, influencing its value in turn. In the context of valuations, this affects both the amount of future financial surpluses and the cost of capital.

It remains to be seen whether the companies' business models will be able to respond to the changed framework conditions, especially the rise in energy prices, at an appropriate speed. If so, the negative effects on company values should be limited. Maybe companies will also use the changing external factors as an opportunity to reposition themselves and their business model to be more resilient, creating new value thereby. Failure to avoid risen energy costs, to use alternative energy sources, or to fully pass on increased expenses to customers will result in the current energy crisis having a negative impact on company values.