12/27/09

Bankers: When you're building a model how do you account for inflation? Before discounting FCF do you account for inflation there or at each step leading to FCF?

Comments (16)

12/27/09

Are you referring to an LBO model or a DCF? If you're talking about a strict leverage buyout model, you really don't count for inflation at all, and you shouldn't.

If you're talking about a DCF, you can account for it any way you'd like, or no way at all. What I've done, and I've never seen any other way, is to simply calculate your free-cash-flow for each period, excluding the impact of inflation/"time" if you will. Then, once you have your stream of cash flows, apply a discount rate (use WACC if you like), and you're good to go. I've never seen a separate breakout of inflation in a model.

Don't take this method as gospel though -- the bank I worked at did very little modeling compared to those at the bulge brackets.

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12/27/09

I'm talking about a DCF.

Oh ok, yeah I guess if you keep everything nominal then you wouldn't need to account for inflation.

12/27/09

You CAN account for inflation in the discount rate used in a DCF (i.e. add projected inflation to WACC), but that's pretty unusual and I wouldn't advise doing this unless your MD/superiors specifically asked for it.

Tough to predict inflation for forward periods, and including it in your discount rate adds yet another assumption to a valuation technique that is primarily driven by assumptions.

12/27/09

Why would you add inflation? it's all being discounted to current levels ....

12/27/09

**Not 100% on this one, so someone correct me if I'm incorrect, but this is how I think about it**

Inflation is not calculated when you discount the CF. You're just taking it back to PV, based on the returns expected by debt & equity investors. This number, WACC, can and generally includes a size/risk premium, but it doesn't adjust for inflation. Adding projected inflation (whatever the hell that number is, say 2.5%) will increase the discount rate (decreasing PVs of future CFs), which is sort of what OP is shooting for here. As inflation increases, the value of the dollar decreases, which is why the present value of those future cash flows affected for inflation is lower than the cash flows unaffected for inflation. DCFs generally do not account for inflation going forward.

Again, this is just my take on the question.

12/28/09

He's basically saying that when you discount, you should discount the future cash flows more because of inflation

but at that point you won't have 1 discount factor and it gets wayyy too complicated. Plus, transactions are done on nominal terms anyway so why bother with real terms? The risk free rate, etc all these things are nominal values

12/28/09

The riskfree rate that is embedded in the discount rate will build on the expected inflation rate (and real growth in the economy)

12/28/09

risk free rate is not inflation adjusted - its not the yield on tipes .its nominal treasury yields ....

12/28/09

I am guessing on this one...

In case one wants to accounts for inflation, doesn't it make sense to use real interest rate instead of nominal when projecting cash flow in future?

12/28/09

WACC is going to include an equity risk premium for the EQ component commensurate with the returns investors expect on the equity (investors aren't blind to inflation: they think in terms of cash and real returns). The debt component obviously takes into account inflation as the rate that the company could refi all its debt is based on the yield curve (which has inflation expectations baked in). Seems like inflation is implicit to any WACC calculation.

12/28/09

risk free rate aint same as tips yield

12/28/09

According to Damodaran the risk free rate is adjusted for inflation

12/28/09

EDIT: Thanks for the explanation below, dagobert. I see what you are saying. Amazing that I can be in banking and completely wiff on that one haha

12/28/09

ERP is the excess return of stocks over the risk free rate. Shifts in the risk free rate are caused by expected inflation and real economic growth. If country A has a higher inflation compared to country B, than country A has a higher risk free rate and vice versa (ignoring economic growth figures).

Keep in mind that the risk free rate is the rate on treasuries (i.e. government bonds). This rate will increase if inflation increases, because one might expect that the ECB/FED will increase their fed funds rate/refinancing rate (in line with their monetary objectives). The same counts for regular bonds, investors wants to be compensated for higher inflation and therefore will ask higher coupon rates. So indirectly the ERP is adjusted for inflation, because of these movements in the risk free rate.

However, if inflation is relatively high, investors are biased towards the equity markets, because it is not 'profitable' to invest in bonds or to put money in a savings account. This might increase stock returns, but from my point of view the efficient market will correct this effect in which there are no arbitrage opportunities.

In reply to dagobert_duck
12/28/09

dagobert_duck:
ERP is the excess return of stocks over the risk free rate. Shifts in the risk free rate are caused by expected inflation and real economic growth. If country A has a higher inflation compared to country B, than country A has a higher risk free rate and vice versa (ignoring economic growth figures).

Keep in mind that the risk free rate is the rate on treasuries (i.e. government bonds). This rate will increase if inflation increases, because one might expect that the ECB/FED will increase their fed funds rate/refinancing rate (in line with their monetary objectives). The same counts for regular bonds, investors wants to be compensated for higher inflation and therefore will ask higher coupon rates. So indirectly the ERP is adjusted for inflation, because of these movements in the risk free rate.

However, if inflation is relatively high, investors are biased towards the equity markets, because it is not 'profitable' to invest in bonds or to put money in a savings account. This might increase stock returns, but from my point of view the efficient market will correct this effect in which there are no arbitrage opportunities.

Beautiful explanation...thanks a lot for this

12/28/09

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