Financial statements provided by a company are nothing more than historical documents that indicate the financial position of the company at some time in the past. Fast-changing market conditions, investor opinions, and the value of currency all alter the financial position of a corporation. Inflation is but one influence on the discrepancy between the book and market values of assets that are listed on a firm’s financial records.
According to Dictionary.com, inflation is defined as:
a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency
Essentially, as more money enters an economic system, prices will rise to compensate for the increase in the amount of money circulating in the system. Because of inflation, it takes more money to buy something today than it did yesterday and it will cost even more tomorrow. From the twenty years from about 1988 to 2008, inflation increased prices by a factor of about 1.65x. In other words, something that cost $1.00 in 1988 cost about $1.65 in 2008, a 65% increase due to inflation.
Figuring inflation is nothing more than a simple time value of money calculation. For example suppose that 2% annual inflation is expected over the next five years. How much will something that costs $1.00 today cost in five years? The future value formula is given as:
FV = PV * (1 + r)n
where FV is the Future Value, PV is the Present Value, r is the inflation rate, and n is the number of years. So, the inflation rate of 2% in five years is:
FV = 1.00 * (1 + 0.02)5
It is also possible to figure out the price of something in the past by using the Present Value formula:
PV = FV / (1 + r)n
To find out the price of something five years assuming 2% inflation per year at a cost of $1.00 today, use the Present Value formula as:
PV = 1.00 / (1 + 0.02)5
The Problem with Inflation
When prices in the market change because of inflation, the market value of an asset changes to reflect the increase (or decrease in a period of deflation). Recall that assets are recorded in a corporation’s books as the value at the time of purchase. A new machine purchased at $25,000 will be recorded at a value of $25,000.
The problem with inflation is not so much the cost of things but buying power. If a person takes a job making $30,000 a year and is still making $30,000 ten years later, the time value of money suggests that this person has lost buying power due to inflation even though the salary remained the same. The nominal amount of money he/she makes is only one aspect of wealth. The effects of inflation combined with the $30,000 will indicate the buying power of the individual. Over the ten years, this individual has lost buying power and is worse off because his/her salary did not increase to keep up with inflation.
Similarly, a machine may be on a firm’s books at $25,000 but because of inflation, the actual value of the asset is constantly changing. The longer the machine sits on the books, the greater the chance the book value and market value of the machine will be different. Even if by some chance the value of the asset after five years was still $25,000 it would be worth less than the purchase price of $25,000 because after five years the value of money is worth less due to inflation.
Inflation can silently erode value when only nominal amounts of money are considered in valuing any asset. Inflation creates discrepancies between book values and market values because the longer an asset sits on the books, the more time inflation has to devalue the dollar. Investors are keenly aware of this phenomenon and are careful to note when assets were purchased. Without an understanding of the effects of inflation on assets, overvaluing of an asset can occur changing the expected returns of an investment.
This post is part of the series: Accounting Statements as Historical Documents: Important Issues for Investors
Financial statements are nothing more than historical documents that show what a company once looked like at some time in the past. They do not indicate any information about actual cash flows or the value of assets and liabilities that still appear on the company’s books.
- Time Since Acquisition as a Factor Affecting Book and Market Value of a Company
- How Inflation Affects the Market Value and Book Value of Assets
- How Liquidity Affects Market Value and Book Value of an Investment
- How Investors View the Differences between Tangible and Intangible Assets
- Equity and Market Value: How Much is a Company Worth to an Investor?