Valuation, 7th Edition

26Inflation

High-inflation environments make analyzing and forecasting companies’ financial performance a challenge. Inflation distorts the financial statements, adding to the difficulty of year-to-year historical comparisons, ratio analyses, and performance forecasts.

When inflation is high, analysis and valuation depend on insights from both nominal- and real-terms approaches. Sometimes nominal indicators are not useful (e.g., for capital turnover). In other cases, real indicators are problematic (e.g., when determining corporate income taxes). But when properly applied, valuations in real and nominal terms should yield an identical value.

Although all the familiar tools described in Part Two still apply to periods of high inflation, such times cause particular complications. This chapter discusses the following issues:

• How inflation leads to lower value creation in companies, because it erodes real-terms free cash flow (FCF), as companies don’t increase prices enough to overcome higher capital costs as well as operating costs
• How to evaluate a company’s historical performance when inflation is high
• How to prepare financial projections of a company’s performance in both nominal and real terms

Inflation Leads to Lower Value Creation

Since the 1980s, inflation has generally been mild in the developed economies of Europe and North America, at levels around 2 to 3 percent per year. But this does not mean inflation has become irrelevant. As Exhibit 26.1 shows, the situation ...