Why Inflation needs to be factored when assessing the Value of a Business

There are some fabulous stocks in the stock market that is very stable, but is no longer growing. So can we still assess the value?

Let me give you an example.

Say we are assessing a chicken rice business in a mature estate in Singapore.
The chicken rice shop has regular customers in that estate so its net revenue (or sales of food) is very steady, but there is no growth.
so by right, when we check the Net Income it should also be stagnant.
But due to inflation, the price of the the cooking ingredients will increase, and the coffee shop will then also have to rise prices to pass the cost down to the customers. Interestingly, this will cause their net profit to increase (at the rate of inflation).
Every year, the shop sells 100,000 plates of chicken rice.
The costs of making a plate of chicken rice = $1.
The selling price of a plate of chicken rice = $2.50
Thus the net profit per plate is $2.50 – $1 = $1.50
The Net profit for the Business = $150,000
Say 10 years later, inflation grew by 100% and all prices doubled.
So the costs of producing the plate of chicken grew from $1 to $2.
The selling price also doubled from $2.50 to $5.
The net profit per plate = $5 – $2 = $3 (also doubled).
So while the number of plates of chicken rice remains at 100,000 plate, the net profit is now $3 x 100,000 = $300,000 (double also).
Now, back to the calculation.
If we have confidence in the chicken rice shop that it will still be around 10 years from today, but expect zero growth. The shop is only worth how much profits it can make us in today’s value.
So for e,g, we already see that the Net Profit for 2012 = $150,000.
What will net the Net Profit in 2013, 2014, 2015 …. all the way to 10 years later?
We need to factor in that while sales does not grow, (this is known as a terminal stage where the business no longer grows)  profit will grow at the inflation rate.
So we project the profits at inflation rate
2012 = $150,000
2013 = $156,000
2014 = $162,240
We then discount each individual profits for each individual year back to today’s value based on our desired returns (also known as discount rate. Some  other investors may use government bond rates as a discount rate).
And then we add up all the future profits that is already discounted back to today’s value and that will be our Net Present Value (or a more accurate term will be our Net Present Target Buying Price) for the business.

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Mind Kinesis Research Team

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