Major external shocks can leave clear marks on corporate financials, making valuations significantly more challenging.
This becomes particularly difficult when such shocks are not purely one-off events, but may reasonably recur in the future.
Recent geopolitical developments in the Middle East illustrate this issue. Armed conflict, such as the current war involving Iran, has the potential to affect energy markets, logistics routes, and regional operations. Firms operating in the energy sector or with significant Middle Eastern exposure may see noticeable impacts in their quarterly—and possibly annual—financial results.
For valuation professionals, the key question becomes: how should these disruptions be reflected in valuation models?
The Normalisation Approach
One option is to treat the event as non-representative of the long-term earnings power of the business.
In this case, the analyst attempts to normalise the financials, using trendlines or multi-year averages to estimate what a “typical” year would look like. The abnormal year is effectively smoothed out when forecasting future cash flows.
This approach was widely used during the COVID-19 pandemic. For many businesses, FY2020 and FY2021 were treated as non-baseline years when setting corporate targets or conducting valuations.
For valuation purposes such as strategic planning or long-term investment analysis, this can be a reasonable approach.
However, not all valuation contexts allow such simplification.
When Shocks Cannot Be Ignored
In many cases, the event cannot simply be brushed aside.
If geopolitical instability, climate events, or supply chain disruptions are expected to occur periodically, they represent a structural feature of the business environment rather than a temporary anomaly.
In such cases, the valuation must explicitly incorporate the risk.
Two common approaches exist.
1. Adjusting the Cash Flow Profile
One method is to incorporate shock scenarios directly into the forecast cash flows.
For example, analysts may model periodic “trough years” where revenues fall, costs increase, or supply chains are disrupted.
Examples could include:
- armed conflict affecting energy markets
- extreme weather disrupting operations
- geopolitical sanctions affecting supply chains
This approach effectively models operational volatility as part of the business cycle.
2. Adjusting the Cost of Capital
An alternative method is to reflect heightened risk in the discount rate.
If the business environment has become structurally more uncertain, investors may demand a higher risk premium. This increases the cost of capital used in valuation.
The justification for this can often be supported through frameworks such as PESTL analysis, which evaluates risk across:
- Political
- Economic
- Social
- Technological
- Legal factors
Increased geopolitical or environmental risks may therefore justify a higher equity risk premium or company-specific risk adjustment.
When Shocks Change the Business Model
Both approaches above assume that the shock does not fundamentally change the underlying business model.
But this assumption may not hold.
Companies facing sustained geopolitical risk may respond by:
- diversifying supply chains
- increasing inventories
- holding more liquidity
- reshoring production
- changing product mixes
Similarly, companies adapting to climate change may alter their operations or investment strategies in response to physical risks.
These adjustments can materially affect working capital, capital expenditure, margins, and ultimately free cash flow.
This is why conversations with management become critical. Strategic responses to external risks often reshape the company’s future financial profile in ways that cannot be captured by simply adjusting a discount rate.
To conclude…
Exogenous shocks are an unavoidable feature of today’s economic environment. Whether driven by geopolitical tensions, climate events, or other external forces, they increasingly shape the financial outcomes of businesses.
For valuation professionals, the challenge lies in determining how these shocks should be treated in financial models. In some cases, normalisation may be appropriate. In others, the risk must be reflected through scenario-based cash flow modelling or adjustments to the cost of capital. And where external shocks lead companies to adapt their strategies, the underlying operating model itself may need to be reassessed.
The key is not to treat disruptions automatically as statistical noise. Instead, analysts must assess whether an event is temporary, recurring, or transformative—and ensure the valuation framework reflects that reality.
In a world where both geopolitical and environmental risks (as well as other risk types) are becoming more prominent, the ability to incorporate such external factors into valuation analysis is likely to become an increasingly important skill.
