Chapter 7: Expected Inflation Rate

The lesson is clear. Inflation devalues us all.

Margaret Thatcher

Inflation is the rate at which prices of goods and services are rising, thereby, the value of a currency is declining. Most commonly, the indexes are the Consumer Price Index (CPI) and Wholesale Price Index (WPI).

Estimating the Expected Inflation Rate is the third step in the Process of Valuation. Expected Inflation is the Expected Inflation Rate of the Currency in which the valuation is done and one expects to be during the forecast and terminal period. The same rate should normally be built into the risk-free rate, the cost of debt and cost of equity, which are used in determining the cost of capital during the forecast and terminal period.

To elucidate: If the real interest rate of a country is 2% and the expected inflation rate is 5.25% then the Risk Free Rate should be 7.25%. Further if a company's default spread is 2.5%, then the pre-tax cost of debt is 9.75%. It is necessary to understand that the risk-free rate is the real interest rate + expected inflation rate which is 2% + 5.25% = 7.25%

One should assume the same inflation rate in the cost of capital else the valuation will be inconsistent. In most cases, we should also assume the impact of inflation on sales growth.

The inflation rate should be of the currency in which the valuation is done. Further, the cost of debt and cost of equity should incorporate the inflation rate assumption.

Price-Led Growth

The expected Inflation Rate built in the Valuation should be the same used in Risk-Free Rate , Cost of Debt and Cost of Equity. Ideally, for Price-Led Growth , it should also be built in the Sales Growth. The Inflation Rate should be of the Currency in which the Valuation is done.

Price-Led Growth is the rate at which sales growth takes place due to the rise in prices. This could happen due to inflation pressures, pricing power, and demand and supply of goods and services.