Inflation Influence on Value

High inflation erodes the value of an organization because passing inflationary pressure onto customers is challenging and often not initiated – managers often do not realize the impact of inflation on value and do not try to raise prices adequately.

The chart shows three scenarios for cash flow generation, assuming the organization does not experience real growth:

• Without inflation;
• 15% inflation, with management increasing operating profit by 15%;
• 15% inflation, with management fully passing the pressure onto customers.

To prevent inflation from eroding the organization’s value (stock prices), management must ensure that the amount of generated free cash flow grows adequately with inflation. However, as the diagram shows, if profits are only increased by 15%, the generated free cash flow decreases…

This is because the calculation of operating profit depreciation is based on the old balance sheet value, while reinvestment in capital is necessary at new inflationary prices. Therefore, CapEx exceeds depreciation, even if the organization does not experience real growth. Rebalancing these two figures takes years (in our example, it took 17 years – Excel Model).

To ensure that cash flows keep pace with inflation, the organization needs to increase operating profit at roughly twice the rate of inflation… Is this possible?

P.S.

There are countries where inflation is consistently high, complicating the lives of their corporations, but in recent years, very high inflation has also been observed in developed countries, making reliance on historical statistics during the evaluation process misleading today. At a minimum, the following points should be considered:

• Growth rates will be overstated because the impact of inflation on nominal figures was very significant;
• Capital turnover rates will also be overstated because long-term assets will be determined at historical prices;
• Operating margins will be overstated because asset depreciation relative to sales will be proportionally reduced;
• Financial leverage indicators may be distorted due to floating interest rates or new loans;

High inflation typically leads to falling stock prices because the market demands higher returns, and the P/E ratio deteriorates significantly, while stock prices return to their old equilibrium after inflation is regulated…

Excel Model

Source: Valuation, Measuring and Managing the Value of Companies – by McK.&Co, T. Koller, M. Goedhart, D. Wessels