Estimated reading time: 3 minutes

The article in brief:

• Impairment testing becomes more intricate during periods of stagflation, requiring companies to carefully assess the impact of macroeconomic conditions on their assets.
• Inflation and stagnant growth can erode purchasing power, impacting revenue streams and cash flow projections, which must be carefully considered in impairment testing.
• Valuation professionals must ensure that discount rates accurately reflect current market conditions, including risk-free rates and corporate bond yields, and that inflation assumptions are consistent in cash flow forecasts and discount rates.

Recent economic headlines from the Wall Street Journal, Fortune, the Business Insider, and other news outlets indicate that conditions consistent with a stagflationary environment – a troubling combination of stagnant growth alongside rising inflation – are becoming more evident in the U.S. economy. Analysts point to softening consumer confidence, a cautious economic outlook, and recent shifts in U.S. trade policy, including new tariffs, as contributing factors. Slower employment growth, a modest rise in unemployment, labor market changes tied to increased deportations, and a depreciation of the dollar are also shaping forecasts, leading many to reassess the potential for a prolonged period of subdued growth coupled with persistent price pressures. 

In such an environment, companies may face heightened complexities in performing impairment tests. Impairment testing, a critical process to ensure that the carrying amount of assets does not exceed their fair value, becomes particularly intricate during periods of stagflation. This article examines the valuation considerations necessary for impairment testing during periods of stagflation, highlighting the challenges and offering valuable insights from valuation professionals.​ 

Understanding Impairment Testing in Stagflation

Impairment testing involves comparing the fair value of a reporting unit with the carrying amount, necessitating a write-down if an impairment is identified. Stagflation can introduce unique challenges to this process. 

Macroeconomic Indicators as Impairment Triggers 

Elevated inflation rates and subdued economic growth serve as potential indicators of impairment. Companies must assess whether these macroeconomic conditions have had a significant impact on their assets. For instance, higher market interest rates, a slowdown in economic activity, and inflation are triggers of possible impairment if they are expected to have, or have already had, a significant adverse effect.​ 

Impact on Cash Flow Projections 

Inflation can erode purchasing power, potentially leading to a decrease in consumer demand and impacting revenue streams. Simultaneously, stagnant growth may limit expansion opportunities. Valuation professionals must carefully assess how these factors impact future cash flow projections, taking into account both the potential for increased costs and the company’s ability to pass these costs on to consumers.​ 

Key Valuation Considerations

In low-inflation environments, valuations are typically conducted in nominal terms, with inflation reflected in both cash flows and discount rates. Even in periods of high and unstable inflation, valuations are still generally performed in these same terms, with inflation assumptions embedded consistently in both the projected cash flows and the discount rate. Maintaining this consistency is critical. 

Inflation, of course, also impacts the cost of materials, services, and labor. Companies must assess their ability to pass these increased costs on to customers without adversely affecting demand. Using general inflation measures, such as the Consumer Price Index (CPI), may not accurately reflect specific cost changes, necessitating a more granular analysis.​ 

The long-term growth rate, integral to calculating terminal value in discounted cash flow (DCF) models, comprises both inflationary and real growth components. Distinguishing between these is important, as real growth typically requires incremental investment to expand operations, while inflationary growth may still require ongoing investment to maintain the current level of business activity. In periods of sustained elevated inflation, the long-term growth rate may need to be revisited to ensure alignment with long-run inflation expectations. 

The Weighted Average Cost of Capital (WACC) is commonly used to estimate appropriate discount rates. Valuation professionals must ensure that discount rates accurately reflect current market conditions, including risk-free rates and corporate bond yields. These WACC inputs will incorporate inflation expectations; therefore, it is essential that the inflation assumptions utilized in any cash flow forecasts are consistent.​

Disclosure and Documentation

Transparency in disclosing key assumptions and judgments is critical, particularly during periods of economic uncertainty. Companies are required to disclose certain key assumptions when testing goodwill and indefinite-lived intangible assets for impairment.​ 

Insights and Resources

Stagflation presents multifaceted challenges for impairment testing, requiring valuation professionals to exercise heightened diligence and adaptability. Companies can effectively navigate these complexities by thoroughly assessing the impact of inflation and stagnant growth on cash flows, discount rates, and asset values and maintaining transparent disclosures. Engaging with expert valuation firms and leveraging their insights can further enhance the robustness of impairment analyses during turbulent economic times. 

VRC works with hundreds of companies to monitor the value of their goodwill as the figure on balance sheets continues to increase steadily. Regular and transparent impairment testing is a necessity, ultimately benefiting companies by acting as a check on dealmaking. We invite you to contact a VRC professional for a more in-depth discussion about current impairment testing standards and how our expertise can help you establish key decision points for testing impairment.