Summary  491 are fairly similar to ROIC and calculated as operating earnings divided by operating capital employed—although the exact definition of earnings and capital varies across applications. Another set of measures, based on cash return on capital, is fundamentally different. They appear under various names, such as cash return on capital invested (CROCI), cash return on gross investment (CROGI), and cash return on assets (CashROA). These cash returns are typically calculated as operating cash flow divided by invested capital:6 Cash Return on Net Invested Capital Operating Cash Flow Net Investe = d Capital Cash Return on Gross Invested Capital Operating Cash Flo = w Gross Invested Capital Unfortunately, such cash returns are flawed measures of value creation, as they do not equal the underlying IRR. In Exhibits 25.1 and 25.2, the cash returns on both gross and net invested capital overestimate the true underly- ing IRR. The main reason is that these cash returns on capital fail to account for the charge of depleting the underlying capital, because they ignore de- preciation charges.7 For the cash return on invested capital net of cumulative depreciation, the error is magnified, as the denominator becomes smaller over the lifetime of the asset. This makes the overestimation of IRR even worse, as indicated by the results for operating cash flow divided by net invested capi- tal in Exhibits 25.1 and 25.2. Because of these variances from IRR, we advise against using cash returns on capital as measures of business performance. Summary For most businesses, ROIC is a good measure of return on capital. It accurately reflects the economic return, as defined by the internal rate of return of the cash flows that the business generates. In addition, it is derived from information that is readily available from standard financial reports, and it is easy for man- agers to understand. For businesses with high up-front investments in capi- tal that generate steady cash flows for many years, you can consider whether using CFROI justifies the additional effort and complexity relative to ROIC. 7 CFROI is also based on operating cash flows, but it includes an implicit charge for the use of the underlying assets, because it is calculated as the IRR over the lifetime of the asset. The simple “cash return” discussed here equals CFROI if the lifetime of the asset is infinite. 6 See, for example, P. Costantini, Cash Return on Capital Invested: Ten Years of Investment Analysis with the CROCI Economic Profit Model (Amsterdam: Elsevier, 2006). 493 26 Inflation High-inflation environments make analyzing and forecasting companies’ fi- nancial performance a challenge. Inflation distorts the financial statements, adding to the difficulty of year-to-year historical comparisons, ratio analyses, and performance forecasts. When inflation is high, analysis and valuation depend on insights from both nominal- and real-terms approaches. Sometimes nominal indicators are not useful (e.g., for capital turnover). In other cases, real indicators are prob- lematic (e.g., when determining corporate income taxes). But when properly applied, valuations in real and nominal terms should yield an identical value. Although all the familiar tools described in Part Two still apply to periods of high inflation, such times cause particular complications. This chapter dis- cusses the following issues: • How inflation leads to lower value creation in companies, because it erodes real-terms free cash flow (FCF), as companies don’t increase prices enough to overcome higher capital costs as well as operating costs • How to evaluate a company’s historical performance when inflation is high • How to prepare financial projections of a company’s performance in both nominal and real terms Inflation Leads to Lower Value Creation Since the 1980s, inflation has generally been mild in the developed economies of Europe and North America, at levels around 2 to 3 percent per year. But this does not mean inflation has become irrelevant. As Exhibit 26.1 shows, the situation was quite different in the 1970s, when inflation hovered around 494  Inflation 10 percent for the same economies. A return to such levels is unlikely, but some economists are warning of rising inflation in, for example, the United States as a result of rising wage levels, import tariffs, and government deficits.1 And some of the largest economies in Latin America and Asia—such as, for example, Brazil, China, and India—as well as Russia have faced inflation at double-digit levels for intervals of many years. In stark contrast, Japan has experienced extremely low inflation and even deflation since the early 1990s. Inflation often persists, stretching over several years as it did during the 1970s and 1980s, because suppressing it requires strict and unpopular gov- ernment measures. For example, curbing inflation caused by overheating in the economy typically requires increasing interest rates and reducing public spending to dampen growth. In most cases, such measures are undertaken 1 See, for example, J. Lahart, “Get Ready to Worry about Inflation Again,” Wall Street Journal, December 12, 2018; or M. Feldstein, “The Fed Must Reassure Markets on Inflation,” Financial Times, June 28, 2009. EXHIBIT 26.1  Historical Inflation Rate in Developed and Emerging Economies Annual CPI-based inflation rate, % 1975 1980 1985 1990 1995 2000 2005 2010 2015 High-inflation economies Low-inflation economies 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 1970 –10 0 10 20 30 Germany United Kingdom Japan United States India Brazil China Russian Federation –10 0 10 20 30 Source: World Development Indicators, The World Bank. Creative Commons Attribution 4.0 International license (CC-BY 4.0).