A Note on Nominal & Real Cash-Flows

A problem most people face while dealing with valuations is the adjustment in inflation. Inflation being a volatile number in India, most valuers tend to ignore it. In usual practice we see valuers using nominal interest rates and real cash flows without adjusting for inflation at all. This assumption holds true when prices are very inelastic and inflation is zero. However, most products do not follow this rule.

 

So before we delve into what is the correct way to value cashflows, let us first understand the culprits in the situation – nominal & real interest rates and nominal & real cash flows.

 

Nominal interest rates are interest rates quoted by the agency. For example, if the Indian Government is issuing 3.15% T-Bills on 19 Aug 2020, then the nominal rate of interest offered by the Indian Government on those T-Bills is 3.15%. The Real Interest Rate is given by

 

Real Interest Rate = Nominal Interest Rate – Inflation

 

We will get back to inflation in a moment. Regarding cash flows, the basic model remains as

 

Revenue = Capacity * Capacity Utilization * Sale Price

Or Revenue = Past Revenue * Growth

 

Without really caring about where this growth is coming from. As long as the growth is consistent with the past growth, we are comfortable with our valuation. However, it is very imperative to know whether the growth is a result of increase in sale prices, or increase in scale of operations, or the more likely scenario – both! If the growth is on account of increase in sale prices only, then it is not a “real” growth but only in nominal terms. However, if we do not consider the growth in sale prices, then it would be unfair to discount the cash flows at nominal interest rates.

 

The principle that emerges is – Real Cash-Flows must be discounted at Real Interest Rates and Nominal Cash-Flows must be discounted at Nominal Interest Rates.

 

Let’s say we have a cash-flow where we’re using nominal rates. The discount rate is the same as quoted by the market in terms of nominal rates of risk free rates and market premiums. Whereas the cash-flows are being increased in accordance with inflation year-on-year. If we were to convert the same cash-flow to real rates, we would have to reduce the discount rates by inflation and the increase in cash-flows would be reduced to the extent of inflation. The net value of the cash-flows should remain the same. Which makes sense as there should be no effect of inflation on the Valuation Date. It should only affect future cash-flows which are being valued in the discounting model.

 

Next we address the elephant in the room. What should be the inflation rate. Take 10 different sources and they will all give you a different rate of inflation. Broadly, there’re two major measures of inflation – the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). In the long run, both these rates have displayed similar characteristics. Some might even take the long-term increase in gold-prices to be a measure of inflation. However, all these measures are backward-looking and discounting of cash-flows has to be done on a forward-looking basis. The issue remains unresolved at the moment and the closest estimate often taken is a 4% inflation rate given the RBI’s present inflation target.

 

Even as the issue for the measure of inflation remains unresolved, it is prudent to be aware that the discounting of cash-flows must be consistent with the interest rates taken. Otherwise we remain unaware of our own shortcomings while estimating valuations under the discounted cash-flow approach.