282  Forecasting Performance competition from low-cost carriers intensified. Network carriers could no lon- ger distinguish business travelers, their primary source of profit, from leisure travelers. As the average price dropped, costs rose as a percentage of sales. But were airlines truly becoming higher-cost?17 And how would this trend continue? To forecast changes more accurately, it is necessary to separate price from volume (as measured by seat-miles). Then, instead of forecasting costs as a percentage of revenues, forecast costs as a function of expected quantity—in this case, seat-miles. The same concept applies to advances in technology. For instance, rather than estimate labor as a percentage of revenues, you could forecast units per employee and average salary per employee. Separating these two drivers of labor costs allows you to model a direct relationship between productiv- ity improvements from new technology and estimated changes in units per employee. Fixed versus Variable Costs When you are valuing a small project, it is important to distinguish fixed costs (incurred once to create a basic infrastructure) from variable costs (correlated with volume). When you are valuing an individual project, only variable costs should be increased as revenues grow. At the scale of most publicly traded companies, however, the distinction between fixed and variable costs is often immaterial, because nearly every cost is variable. For instance, consider a mobile-phone company that transmits calls using radio-frequency towers. In spite of the common perception that the tower is a fixed cost, this is true for only a given number of subscribers. As subscribers increase beyond a certain limit, new towers must be added, even in an area with preexisting coverage. (A small company adding 1,000 custom- ers can leverage economies of scale more than a large company adding 100,000 customers.) What is a fixed cost in the short run for small increases in activity becomes variable over the long run even at reasonable growth rates (10 per- cent annual growth doubles the size of a company in about seven years). Since corporate valuation is about long-run profitability and growth, nearly every cost should be treated as variable. When an asset, such as computer software or a mobile app, is truly ­scalable, its development cost should be treated as a fixed cost. Be careful, however. Many technologies, such as computer software, quickly become obsolete, requiring new incremental expenditures for the company to remain competi- tive. In this case, a cost deemed fixed actually requires repeated cash outflows, just not in traditional ways. 17 For example, Spirit Airlines dedicates a higher percentage of revenue to labor than American Airlines does. In terms of cost per seat-mile, however, American is the higher-cost airline of the two. Advanced Forecasting  283 Incorporating Inflation In Chapter 10, we recommended that financial-statement forecasts and the cost of capital be estimated in nominal currency units (with inflation), rather than real currency units (without inflation). To remain consistent, the nomi- nally based financial forecast and the nominally based cost of capital must reflect the same expected general inflation rate. This means the inflation rate built into the forecast must be derived from an inflation rate implicit in the cost of capital.18 When possible, derive the expected inflation rate from the term structure of government bond rates. The nominal interest rate on government bonds re- flects investor demand for a real return plus a premium for expected inflation. Estimate expected inflation as the nominal rate of interest less an estimate of the real rate of interest, using the following formula: Expected Inflation Nominal Rate Real Rate = + + − ( ) ( ) 1 1 1 To estimate expected inflation, start by calculating the nominal yield to maturity on a ten-year government bond. But how do you find the real rate? Many countries, such as the United States, United Kingdom, and Japan, issue inflation-linked bonds (ILBs). An ILB is a bond that protects against inflation by growing the bond’s coupons and principal at the consumer price index (CPI). Consequently, the yield to maturity on an ILB is the market’s expectation of the real interest rate over the life of the bond. In March 2019, the yield on a ten-year U.S. Treasury bond equaled 2.57 percent, and the yield on a U.S. Treasury inflation-protected security (TIPS) bond equaled 0.66 percent.19 Unlike previous decades, when the real rate hovered around 2 percent, the real rate has been volatile during the last ten years, even drop- ping below zero in 2012. To determine expected inflation, apply the previous formula to the data: Expected Inflation = − = 1 0257 1 0066 1 0 0190 . . . Expected inflation, as measured by the difference in nominal and real bonds, equals 1.90 percent annually over the next ten years. 18 Individual line items may have inflation rates that are higher or lower than the general rate, but they should still derive from the general rate. For example, the revenue forecast should reflect the growth in units sold and the expected increase in unit prices. The increase in unit prices, in turn, should reflect the generally expected level of inflation in the economy plus or minus an inflation rate differential for that specific industry. Suppose general inflation is expected to be 4 percent and unit prices for the com- pany’s products are expected to increase at one percentage point less than general inflation. Overall, the company’s prices would be expected to increase at 3 percent per year. If we assume a 3 percent annual increase in units sold, we would forecast 6.1 percent annual revenue growth (1.03 × 1.03 − 1). 19 10-Year Treasury Constant Maturity Rate (DGS10) and 10-Year Treasury Inflation-Indexed Security, Constant Maturity (FII10), Federal Reserve Bank of St. Louis.