Sound analysis and forecasting of the financial performance of companies in high-inflation environments is challenging. Inflation distorts the financial statements, adding to the difficulty of making year-to-year historical comparisons, ratio analyses, and performance forecasts.
Although all the familiar tools described in Part Two still apply in times of high inflation, such times cause some particular complications that we discuss in this chapter:
• History shows that inflation leads to lower value creation in companies, because it erodes real-terms free cash flow (FCF) and increases the cost of capital.
• Historical analysis of a company’s performance when inflation is high requires additional metrics in real terms.
• Financial projections of a company’s future performance should be made in both nominal and real terms whenever possible.
As we explain in this chapter, when inflation is high, analysis and valuation depend on insights from both nominal- and real-terms approaches. Nominal indicators are sometimes not meaningful (e.g. for capital turnover), and 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.
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 ...