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. 284  Forecasting Performance Exhibit 13.14 presents annualized growth in the U.S. consumer price index (CPI) versus expected ten-year inflation implied by traditional U.S. Treasury bonds and U.S. TIPS bonds. Since the ten-year TIPS bond is based on long- term inflation, the implied inflation rate is much more stable than the one-year change in CPI (in mid-2008, CPI grew at more than 5 percent when crude oil spiked, only to crater after the recession as companies cut prices to generate demand). Since 2000, actual and implied inflation have both hovered around 2 percent annually. Inflation can distort historical analysis, especially when it exceeds 5 per- cent annually. In these situations, historical financials should be adjusted to reflect operating performance independent of inflation. We discuss the impact of high inflation rates in Chapter 26. Concluding Thoughts In this chapter, we provided a detailed line-by-line process to create a set of financial forecasts. While it is important that the model reflect the complexities of the business you are analyzing, always keep a close eye on the bigger pic- ture. Make sure resulting value drivers, such as ROIC and growth, are consis- tent with the past performance of the business and the industry’s economics. When the model is complete, use the model to test the importance of various inputs. A sensitivity table can provide insight on not only the valuation but also on the actions management must undertake to capture it. EXHIBIT 13.14  Expected Inflation versus Growth in the Consumer Price Index % –3 –2 –1 0 1 2 3 4 5 6 2002 2004 2006 2008 2010 2012 2014 2016 2018 2000 Annualized growth in the consumer price index Implicit expected inflation as derived using 10-year U.S. TIPS bonds Source: Federal Reseve Bank of St. Louis.