How does inflation affect the DCF Value?
So I was asked this in a recent interview, and while I mentioned the factors (Unlevered FCF will increase because revenue, COGS increases) and the discount rate is affected because the cost of debt factors in inflation through the risk-free rate (not sure about this, and does cost of equity get affected too) I was unsure when he asked - does the overall value the DCF spits out increase?
Do any monkeys have an explanation for this? I feel like although I know the steps of the DCF on the back of my hand, I really don't understand some of the factors. Thanks!
A DCF takes accounts for inflation by using nominal interest rates in your WACC calculation, which are based on expected and real interest rates.
Simply, nominal rate = real interest rate + inflation rate. So a higher inflation rate would increase your risk free rate, thus increasing your discount rate and decreasing your enterprise value.
^What the guy above me said in terms of nominal inflation is correct
What I'd also add maybe is that inflation creates a very uncertain environment for business so your growth rate projections in your DCF might be lower than usual, but I assume that the nominal/real inflation rate explanation is what they were aiming that
It also affects the terminal value in the DCF. That's the growth rate you're using.
Interested in this - the typical explanation I’ve heard for using a 2-3% perpetuity growth rate is that it is roughly in like with US GDP growth. But that’s real growth, correct? If DCF is measured in nominal dollars, why can’t you use a higher perp growth rate (3-4% or higher)?
In the extreme case, if there was 5+% inflation expected, would a justifiable perpetuity growth rate be 7%+?
The explanation I was given is bc at some point your company will be larger than the U.S. economy which realistically is improbable.
I would not agree with Prospectus, I think while the rate increases, your nominal FCF also increases, and as such, the value should stay equal (assuming the company has a similar exposure to inflation in costs and revenues).
We can also base that in financial theory, purely nominal changes should not change the intrinsic value of a company.
Lots of factors here, including whether we are considering levered or unlevered free cash flows. Speaking strictly from intuition, for unlevered free cash flows, consider that an increase in inflation will drive interest rates higher thus driving borrowing costs higher and resulting in investors demanding a higher return on their credit investment. For a company with a large amount of debt in its capital structure, this will have a negative effect on its valuation, because the discount rate becomes higher.
For levered free cash flows, also consider that inflation and the incrementally higher interest rates on debt will have a corresponding incremental tax shielding effect. This should be as simple as running a dummy case to see if the rise in cost of debt is offset by reduced cash taxes paid, in spite of a higher interest expense. It is not.
Finally, consider that by definition inflation erodes consumer purchasing power as goods become more expensive. Depending on the industry and how sensitive the goods / services are to price fluctuations, or stated another way how discretionary in nature the purchase of these items are, this may have a small-to-huge effect on a company's topline.
Thanks guys some great stuff here! Sb'ed whoever I could My final question is what happens to the value? Is there a straight answer or it depends on the number of factors that are involved?
One poster mentioned that the increase in unlevered FCF in both the explicit and Terminal period should offset the change in the discount rate and theoretically there should be no change. Also maybe the value increases because of the tax shield in the cost of debt?
Bump! Anyone else?
I think that this question can't be answered by a straight yes or a no given that it really depends on the company's industry and economic environment. While a company with a lot of employees on its P&L could benefit from a higher inflation (because workers become cheaper relative to the goods they are producing), it could also negatively be impacted by the increase in interest rates, as mentioned in other posts, since creditors demand an inflation premium when lending over longer periods of time.
My answer is clearly overly simplistic but I would conclude that companies should do better in a 2% inflation environment than in a deflation environment, thus should theorically be valued higher. At the same time, a company evolving in a hyper inflation environment should do worse than a company in a 2% inflation environment, thus its valuation should be lower over the long run.
Great stuff man! Thanks
I have a supplementary questions to the discussion abov On a mining project, on which costs would you apply inflation? For example, for a copper project in indonesia, would you apply IDN inflation rate to all costs or only to costs in local currency? That would excludes potential maintenance cost in USD on equipments. Or I would not impact fuel (oil) costs denominated in USD. thank you
DCF in a Country with Hyperinflation (Originally Posted: 05/01/2013)
What is the best way to do a valuation of a company based in an emerging market with hyperinflation?
aaahh.
Thanks!
http://content.yudu.com/Library/A1no7t/TheMckinseyValuation/resources/3…
Well about one US penny = 90 trillion in hyper-inflated currency so you can work from that angle or measure based on how many chickens or whores they take in lieu of payment.
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