Inflation Leads to Lower Value Creation  495 only when everything else has failed and when inflation has become too high to ignore—but even more difficult to fix. It’s necessary to take account of persistent inflation in analysis and valu- ation, because a large body of academic research clearly shows that inflation is negatively correlated with stock market returns.2 To illustrate, as inflation increased from around 2 or 3 percent in the late 1960s to around 10 percent in the second half of the 1970s, the average price-to-earnings (P/E) ratio for companies in the United States declined from around 18 to below 10. When inflation finally came down, from 1985 onward, P/Es returned to their histori- cal levels. Inflation has obvious pernicious effects on value creation. Academic re- search has found evidence that investors often misjudge inflation, which pushes up the cost of capital in real terms and depresses market valuations.3 Inflation creates a one-off loss in value for companies with so-called net mon- etary assets—that is, asset positions that are fixed in nominal terms.4 For example, a balance of receivables loses 10 percent in value when inflation unexpectedly increases by 10 percent. The reverse holds for net monetary li- abilities, such as fixed-rate debt. Depending on the relative size of a particular company’s receivables, payables, and debt, the direct effect could be positive or negative. Companies also can end up paying higher taxes if their deprecia- tion tax shields are not inflation adjusted for tax purposes—and this is typi- cally the case. Inflation’s most value-destroying impact is not obvious. Though com- panies may increase prices, most cannot or do not increase them enough to cover both their higher operating costs (salaries and purchased goods) and the higher cost of future capital expenditures. As a result, they fail to maintain profitability in real terms. To understand how significant the challenge of passing on cost increases can be, consider this simple example. Assume a company generates steady sales of $1,000 per year. Earnings before interest, taxes, and amortization (EBITA) are $100, and invested capital is $1,000. Assume the asset base is evenly spread across 15 groups with remaining lifetimes of 1 to 15 years. Gross property, plant, and equipment (PP&E) is $1,875, and annual capital expendi- tures equal depreciation charges at $125.5 The company’s key financials would 2 See, for example, E. Fama and G. Schwert, “Asset Returns and Inflation,” Journal of Financial Economics 5 (1977): 115–146; and J. Ritter and R. Warr, “The Decline of Inflation and the Bull Market of 1982–1999,” Journal of Financial and Quantitative Analysis 37, no. 1 (2002): 29–61. 3 See, for example, F. Modigliani and R. Cohn, “Inflation, Rational Valuation, and the Market,” Financial Analysts Journal 35 (1979): 24–44; and Ritter and Warr, “The Decline of Inflation,” who found that in times of high inflation, investors tend to capitalize real cash flows at nominal discount rates. 4 See, for example, H. Hong, “Inflation and the Market Value of the Firm: Theory and Test,” Journal of Finance 32, no. 4 (1977): 1031–1048. 5 At the end of each year, after replacement of the asset group that is fully depreciated, the average remaining life of assets is exactly eight years. Annual depreciation is therefore $1,000 ÷ 8 = $125, and gross PP&E equals 15 × $125 = $1,875. 496  Inflation be as shown in Exhibit 26.2. If the cost of capital is 8 percent, the discounted- cash-flow (DCF) value at the start of year 2—or any year—equals: DCF = − ( ) = $ % % $ , 100 8 0 1 250 Now assume that in year 2, inflation suddenly increases to 15 percent and stays at that level in perpetuity, affecting costs and capital expenditures equally. Let’s assume the company increases prices enough that its EBITA grows with inflation and its sales margin (EBITA divided by sales) stays near 10 percent while keeping sales volume and physical production capacity constant. In the process, the company even succeeds in lifting its return on invested capital (ROIC) to almost 20 percent after 15 years (see Exhibit 26.3). Although these results may be impressive at first sight, a closer inspec- tion of the financial performance reveals significant value destruction. Even though EBITA grows at 15 percent per year, growth in earnings before interest, taxes, depreciation, and amortization (EBITDA) is at only 7 to 8 percent per year because depreciation is recorded at historical nominal cost. As a result, capital spending should exceed depreciation charges to keep physical capac- ity constant, leading to an actual decline in free cash flow (FCF) in the first few years. FCF growth only gradually rises to the rate of inflation in year 17.6 EXHIBIT 26.2  Financial Projections without Inflation $ Year 1 Year 2 Year 3 Year 4 Year 16 Year 17 Sales 1,000 1,000 1,000 1,000 1,000 1,000 EBITDA1 225 225 225 225 225 225 Depreciation (125) (125) (125) (125) (125) (125) EBITA2 100 100 100 100 100 100 Gross property, plant, and equipment 1,875 1,875 1,875 1,875 1,875 1,875 Cumulative depreciation (875) (875) (875) (875) (875) (875) Invested capital 1,000 1,000 1,000 1,000 1,000 1,000 EBITDA 225 225 225 225 225 225 Capital expenditures (125) (125) (125) (125) (125) (125) Free cash flow (FCF) 100 100 100 100 100 100 EBITA growth, % – – – – – – EBITA/sales, % 10.0 10.0 10.0 10.0 10.0 10.0 Return on invested capital, % 10.0 10.0 10.0 10.0 10.0 10.0 FCF growth, % – – – – – 1 Earnings before interest, taxes, depreciation, and amortization 2 Earnings before interest, taxes, and amortization 6 Given our assumption of an asset lifetime of 15 years, FCF growth gradually increases from 0 to 15 percent until year 17, when a new steady state is reached if inflation remains constant.