Inflation Leads to Lower Value Creation  497 EXHIBIT 26.3  Financial Projections with Incomplete Inflation Pass-On $ Year 1 Year 2 Year 3 Year 4 Year 16 Year 17 Sales 1,000 1,131 1,283 1,460 7,516 8,644 EBITDA 225 240 259 281 1,210 1,392 Depreciation (125) (125) (126) (129) (397) (456) EBITA 100 115 132 152 814 936 Gross property, plant, and equipment 1,875 1,894 1,934 1,999 6,840 7,866 Cumulative depreciation (875) (875) (876) (880) (2,082) (2,394) Invested capital 1,000 1,019 1,058 1,119 4,758 5,472 EBITDA 225 240 259 281 1,210 1,392 Capital expenditures (125) (144) (165) (190) (1,017) (1,170) Free cash flow (FCF) 100 96 93 91 193 222 EBITA growth, % – 15.0 15.0 15.0 15.0 15.0 EBITA/sales, % 10.0 10.2 10.3 10.4 10.8 10.8 Return on invested capital, % 10.0 11.5 13.0 14.4 19.7 19.7 FCF growth, % 0.0 –3.7 –3.2 –2.4 14.3 15.0 7 With inflation at 15 percent, the cost of capital increases from 8 percent to (1 + 8%) × (1 + 15%) – 1 = 24%. EXHIBIT 26.4  Financial Projections with Full Inflation Pass-On $ Year 1 Year 2 Year 3 Year 4 Year 16 Year 17 Sales 1,000 1,150 1,323 1,521 8,137 9,358 EBITDA 225 259 298 342 1,831 2,105 Depreciation (125) (125) (126) (129) (397) (456) EBITA 100 134 171 213 1,434 1,649 Gross property, plant, and equipment 1,875 1,894 1,934 1,999 6,840 7,866 Cumulative depreciation (875) (875) (876) (880) (2,082) (2,394) Invested capital 1,000 1,019 1,058 1,119 4,758 5,472 EBITDA 225 259 298 342 1,831 2,105 Capital expenditures (125) (144) (165) (190) (1,017) (1,170) Free cash flow (FCF) 100 115 132 152 814 936 EBITA growth, % – 33.7 28.1 24.5 15.1 15.0 EBITA/sales, % 10.0 11.6 13.0 14.0 17.6 17.6 Return on invested capital, % 10.0 13.4 16.8 20.2 34.7 34.7 FCF growth, % 15.0 15.0 15.0 15.0 15.0 Combine this with a cost of capital increase to 24 percent,7 and the com- pany’s value plummets. An explicit DCF valuation with continuing value estimated as of year 17 would show the value at the start of year 2 being as low as $481. 498  Inflation To pass on inflation to customers in full without losing sales volume, the company must increase its cash flows, not its earnings, at 15 percent per year (see Exhibit 26.4). In this case, the DCF value at the start of year 2 is fully preserved: DCF = − ( ) = $ % % $ , 115 24 15 1 250 But having all cash flows grow with inflation means that earnings must in- crease much faster than inflation. As the summary financials show, EBITA growth is now more than 33 percent in year 2. In the same year, the sales mar- gin increases from 10.0 percent to 11.6 percent, and ROIC increases from 10.0 percent to 13.4 percent. After 15 years of constant inflation, the sales margin and ROIC would end up at 17.6 percent and 34.7 percent, respectively. ROIC needs to rise this far to keep up with inflation and the higher cost of capital.8 Although this example is stylized, the conclusion applies to all compa- nies: after each acceleration in inflation, we should expect reported earnings to outpace inflation, and reported sales margin and ROIC to increase—even though, in real terms, nothing has changed. Unfortunately, history shows that in periods of inflation, companies do not achieve such big improvements in reported return on invested capital. ROICs remained in the range of 7 to 12 percent in the United States during the 1970s and 1980s, when inflation was at 10 percent or more. If companies had succeeded in passing on inflation effects, they should have reported much higher ROICs in those years. Instead, they hardly managed to keep returns at preinflation levels. One likely cause is that companies cannot pass on the cost increases to cus- tomers without losing volume, or they can pass on increases only with some time lag. Another reason could be that managers do not sufficiently adjust targets for growth of earnings and sales margin when faced with inflation. If a company keeps its sales margins and ROIC constant in times of inflation, cash flows and value are eroding in real terms. Maintaining EBITA growth in line with inflation is also insufficient to sustain a company’s value; this is even more the case for a leveraged indicator such as earnings per share. Whatever the exact reason, history shows that companies do not manage to pass on inflation in full. As a result, their cash flow in real terms declines. In addition, there is empirical evidence that in times of inflation, investors are likely to undervalue stocks as they misjudge inflation’s effects.9 Lower cash flow and higher cost of capital form a proven recipe for lower share prices, just as occurred in the 1970s and 1980s. 8 The reason is that invested capital and depreciation do not grow with inflation immediately. For example, in year 2, annual capital expenditures increase by 15 percent, but this adds only 15% × $125 = $18.75 to invested capital. Assets are acquired at the end of each year and depreciated for the first time in the next year. Annual depreciation changes in year 3 by only a small amount: 1/15 × 19 = 1.25. In each year, the company replaces only 1/15 of assets at inflated prices, so it takes 15 years of constant inflation to reach a steady state where capital and depreciation grow at the rate of inflation. As the example shows, sales margin and ROIC increase each year until the steady state in year 17. 9 Modigliani and Cohn, “Inflation, Rational Valuation, and the Market”; Ritter and Warr, “The Decline of Inflation.”