Inflation usually impedes the creation of value.
Inflation lowers the value of monetary assets and the firm can rarely pass along the full effects of inflation to customers.
Typically, ROIC does not increase enough to compensate the firm for inflation.
The increase in inflation from the 1960s to the 1970s was accompanied by a decline in P/E ratios.
Periods of High Inflation
During periods of high inflation, the problem becomes much worse.
During periods of high inflation, the following distortions can occur and need to be corrected:
- overstated growth,
- overestimated capital turnover,
- overstated operating margins, and
- distorted credit ratios.
When making forecasts in periods of high inflation, adjustments can be make in either nominal or real terms.but consistent financial projections require elements of both nominal and real forecasts.
Five steps for making forecasts in periods of high inflation are:
- forecast operating performance in real terms,
- build financial statements in nominal terms,
- build financial statements in real terms,
- forecast free cash flow in real and nominal terms, and
- estimate discounted cash flow (DCF) value in real and nominal terms.