A practical guide to understanding inflation and the discounted cash flow (DCF) method

In this article, we will explore how you can adjust for inflation through the discounted cash flow (DCF) method. Before that, we will have a brief discussion on inflation.

A valuable lesson for investors and budding valuation analysts is that a dollar today isn’t worth the same as a dollar tomorrow because of inflation. Global inflation was projected to be around 6.5% in 2023, a decline from 8.8% in 2022. This reflects a broader trend of decreasing inflation rates as economies adjust post-pandemic and respond to monetary policy changes. This idea forms the basis for how we value investments, businesses, and various financial decisions.

In all valuation exercises focusing on assets that pay out over a certain number of years, we always adjust for inflation.

Today, in this article, we will explore how you can adjust for inflation through the discounted cash flow (DCF) method. Before that, we will have a brief discussion on inflation.

What is inflation?

Inflation is the rise in the general price level over a certain period that occurs due to excess demand. The IMF forecasts global inflation to decrease further to about 5.8% in 2024, with expectations of continued moderation due to lower energy prices and improved supply chains.

Changes in the general price level are measured by tracking the weighted average price of a certain basket of goods and services. Typically, when we talk about inflation, we are talking about US Consumer Price Index (CPI) inflation which measures the rise in prices of consumer goods and services.

Since inflation can erode the value of money over time, it is important to factor it into the valuations of assets like a company’s stocks that pay out returns over a long period. Because of inflation, the $10 dividend you receive today has more value than the $10 dividend you receive 2 years later. In simpler terms, you can buy more with the $10 dividend you receive today than with the $10 dividend you receive 2 years later because of inflation.

For instance, on a year-on-year basis, US CPI inflation was 2.4% in September 2024 and 3.7% in September 2023. Based on this, let us see how the value of $10 changed over the last 2 years.

MonthInflationChange in price level since 2022Value of $10 in September 2022
September 20233.70%3.70%$9.64
September 20242.40%6.19%$9.42

So, the goods and services you could buy for $10 in September 2024 would cost $9.42 in September 2022. Similarly, the goods and services you could buy with $10 in September 2023 would cost $9.64 in September 2022.

Let us take a look at US inflation history for the past 20 years.

As you can see, inflation is almost always positive. The only times we have seen inflation significantly below 0% in the last 20 years was during the Great Recession. So, in valuation exercises, we typically assume that inflation will always be positive and as a result, the value of money will always fall.

What is the discounted cash flow (DCF) method? Definition and steps

The discounted cash flow (DCF) method values a company by estimating the current value of its future cash flows. In this method, we are essentially trying to figure out the fair price to pay right now in exchange for all future cash flows of a company. We are discounting the future cash flows based on the idea that money in hand is worth more than money in the future. As we explored earlier, this happens because inflation erodes the value of money over time.

The steps in the DCF method are as follows:

  • Estimate the life of the company in years
  • Estimate the cash flows over its life
  • Discount all cash flows based on the discount rate
  • Sum all the discounted cash flows to arrive at the company’s valuation

In some cases, the discount rate is set equal to the expected inflation. However, if an investment does not grow in inflation-adjusted value or real value, it does not appeal to investors. Hence, nowadays, it is common practice to combine inflation and the expected returns by the investors to arrive at the discount rate.

We can arrive at a fair expected rate of return for investors by considering the following factors:

  • Risk-free rate – A risk-free rate is the rate of return on an investment like government bonds where there is no risk of loss. This forms the baseline for the return expectations of the investor.
  • Market risk premium – The market risk premium is the return over the risk-free rate sought by investors to make up for the risks prevalent in the broader market. This premium is meant to compensate the investor for all the uncertainty and risks that stock market investments carry.
  • Private equity risk premium – Private equity is riskier than the stock market because of the lower liquidity and lesser transparency. Hence, private equity investors seek a premium over the stock market returns to compensate for the additional risk they take.
  • Company-specific risk premium – Since the investor will be investing in a specific company and not all across the private equity market, they are more vulnerable to risks specific to the company. Hence, when you invest in a specific company, you would seek a higher return than if you were investing across the private equity market.

After adding all these components, we just need to adjust for inflation.

In this method, we can calculate the discount rate as:

Discount rate = (1 + Risk-free rate + Market risk premium + Private equity risk premium + Company-specific risk premium) × (1 + Inflation) – 1

Example of discounted cash flow (DCF) method

TechWave Innovations, founded in 2019, is a company that provides enterprise resource planning (ERP) solutions integrating financial management, supply chain operations, and customer relationship management (CRM) under one hood.

The company operates on a subscription model. Currently, 60% of its users are freemium users, 30% are normal subscribers and 10% are premium subscribers. Over the next five years, it is expected that the share of normal subscribers will increase to 45% and premium subscribers will be 20%. The entire user base is increasing by 10% every year.

TechWave Innovations’ financial history for the past five years is as follows:

Particular201920202021202220232024
User base8008809681064.81171.281288.41
Freemium800704726745.36761.33773.04
Subscribers0176161.33212.96273.3386.52
Revenue from subscribers$ -$3,520.00$3,226.67$4,259.20$5,465.97$7,730.45
Premium subscribers0080.67106.48136.65128.84
Revenue from premium subscribers$ -$ -$3,226.67$4,259.20$5,465.97$5,153.63
Total revenue$ -$3,520.00$6,453.33$8,518.40$10,931.95$12,884.08
Overhead costs$20.00$20.00$20.00$20.00$20.00$20.00
Operating costs$800.00$1,056.00$1,290.67$1,490.72$1,717.88$1,932.61
Total expenditure$820.00$1,076.00$1,310.67$1,510.72$1,737.88$1,952.61
Net cash flow-$820.00$2,444.00$5,142.67$7,007.68$9,194.07$10,931.47

After some financial modeling, we can make the following financial projections for TechWave Innovations.

Particular (in thousands)20252026202720282029
User base1417.251558.971714.871886.362074.99
Freemium779.49857.44771.69848.86726.25
Subscribers467.69483.28668.8697.95933.75
Revenue$9,353.84$9,665.64$13,375.99$13,959.05$18,674.95
Premium subscribers170.07218.26274.38339.54415
Revenue$6,802.79$8,730.25$10,975.17$13,581.78$16,599.95
Total revenue$16,156.64$18,395.89$24,351.17$27,540.83$35,274.90
Overhead costs$20.00$20.00$20.00$20.00$20.00
Operating costs$2,225.08$2,478.77$2,932.43$3,263.40$3,838.74
Total expenditure$2,245.08$2,498.77$2,952.43$3,283.40$3,858.74
Net cash flow$13,911.56$15,897.12$21,398.74$24,257.43$31,416.16

The average inflation for the last 20 years was 2.57% and the current 5-year US Treasury rate is 3.997%. We will make the following assumptions:

ParticularsAmount
Market risk premium6%
Private equity risk premium15%
Company-specific risk premium4%

Now, let us calculate the discount rate.

Discount rate = (1 + 3.997% + 6% + 4%) × (1 + 2.57%) – 1
= (1 + 16.997%) × (1 + 2.57%) – 1
= 120.01% – 1
= 20.01%

Now, let us discount the net cash flows based on this discount rate to find TechWave Innovations’ valuation.

ParticularNet cash flowDiscounted net cash flow
2025$13,911.56$11,592.04
2026$15,897.12$11,037.90
2027$21,398.74$12,380.56
2028$24,257.43$11,694.48
2029$31,416.16$12,620.41
Total$59,325.39

As per the DCF method, TechWave Innovations is worth $59.33 million.

Eqvista – Turning numbers into insights and insights into fortunes!

This article focused on how the rise in general price levels, or inflation, erodes the buying power of money and how we can factor this into company valuations. We focused on the discounted cash flow (DCF) method where we estimate cash flows and discount them based on the expected returns and inflation.

In our formula, we added the risk-free rate and all the premiums for market risk, private equity risk, and company-specific risks and then adjusted for inflation to get the discount rate.

Later on, we displayed a summary of how a DCF company valuation would play out in real life.

If you need assistance in uncovering your company’s true value in today’s market, consider relying on Eqvista’s team of valuation specialists.

With deep expertise across diverse industries and proficiency in a range of financial models, we deliver accurate, reliable valuations tailored to your business needs. Contact us to know more!

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