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How do you adjust a discounted cash flow analysis for inflation?

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Discounted cash flow (DCF) analysis is a valuation method that projects the future cash flows of a business or project and discounts them to their present value. However, inflation can affect the accuracy of a DCF analysis by eroding the purchasing power of money over time. Therefore, it is important to adjust a DCF analysis for inflation to reflect the real value of cash flows in today's terms. In this article, you will learn how to adjust a DCF analysis for inflation using two common approaches: the nominal method and the real method.

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ATHIRA SELVARAJ

Fraud Investigation and Risk Management, Financial planning services, Chartered Accountancy- Level II, Post graduation…

1 Nominal method

The nominal method uses nominal cash flows and nominal discount rates to calculate the present value. Nominal cash flows are the expected cash flows without adjusting for inflation, while nominal discount rates are the required rates of return that include inflation expectations. To use the nominal method, you need to estimate the nominal cash flows for each period and apply the nominal discount rate to discount them. The nominal discount rate can be derived from the capital asset pricing model (CAPM) or the weighted average cost of capital (WACC) formula, which incorporate the risk-free rate, the market risk premium, and the inflation premium.

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2 Real method

The real method uses real cash flows and real discount rates to calculate the present value. Real cash flows are the expected cash flows after adjusting for inflation, while real discount rates are the required rates of return that exclude inflation expectations. To use the real method, you need to estimate the real cash flows for each period and apply the real discount rate to discount them. The real discount rate can be obtained by adjusting the nominal discount rate using the Fisher equation, which relates the nominal, real, and inflation rates as follows: 1 + nominal rate = (1 + real rate) x (1 + inflation rate) Alternatively, you can use the approximation formula: nominal rate = real rate + inflation rate

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ATHIRA SELVARAJ

Fraud Investigation and Risk Management, Financial planning services, Chartered Accountancy- Level II, Post graduation in Commerce, Post graduate diploma in International Business Operations.
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To incorporate inflation into a Discounted Cash Flow (DCF) analysis using the real method, you typically adjust the cash flows and discount rate. Adjust the future cash flows by incorporating an inflation rate to reflect the expected increase in costs or revenues. Then, use a real discount rate, which accounts for both the time value of money and inflation. It can be calculated using the formula : (1+nominal discount rate/ 1+ inflation rate)-1 This adjusted rate is then used to discount the real, inflation-adjusted cash flows. The goal is to express all cash flows and the discount rate in constant (real) dollars to provide a more accurate representation of the project's value in today's terms, considering the impact of inflation.

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3 Pros and cons

Both methods should yield the same present value if applied correctly and consistently. However, they have different advantages and disadvantages depending on the context and assumptions. The nominal method is easier to apply when nominal cash flows and discount rates are available or observable from the market. Yet, it can be more complex and prone to errors when the inflation rate changes over time or across different cash flow components. On the other hand, the real method is more intuitive and consistent when real cash flows and discount rates remain stable and reflect the underlying growth and risk of a business or project. Nevertheless, it can be more difficult and take longer to apply when real cash flows and discount rates are not directly observable or need to be adjusted for taxes, depreciation, or other factors.

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4 Tips and best practices

Adjusting a DCF analysis for inflation effectively requires following some tips and best practices. Choose the method that suits your data and assumptions and use reliable and consistent sources of information for the cash flows, discount rates, and inflation rates. Additionally, check the sensitivity of your results to changes in the inflation rate and other key variables, then compare your results with other valuation methods or benchmarks to validate your assumptions and conclusions.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How do you adjust a discounted cash flow analysis for inflation?

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1 Nominal method

2 Real method

3 Pros and cons

4 Tips and best practices

5 Here’s what else to consider

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