When inflation is high and expected to stay there a while, metrics like EBITA and ROIC can be less reliable as indicators of performance. To understand why, look at the relationship among EBITA, ROIC, and a company’s cash flow. Long-term inflation can erode cash flows, which can affect the value of a company.
To preserve that value, a company’s free cash flow must keep pace with inflation for a no-growth company. But what happens to EBITA and ROIC at the same time? Depending on the type and age of a company’s assets, EBITA and ROIC may need to increase by more than the inflation level itself (exhibit).
A focus on EBITDA may not paint a full picture, either, despite the fact that EBITDA margins are constant. Why? It all comes down to accounting. Inflation can affect current and future capital expenditures. But depreciation is mostly driven by past expenditures and, therefore, is not inflated.
That’s why, when building budgets, it’s better to focus on real-term cash flows than on EBITA and ROIC, which are likely to be distorted by inflation. Financial ratios should be inflation adjusted, and managers should closely monitor inflation-robust metrics.
Vartika Gupta is a solution manager in McKinsey’s New York office, where David Kohn is an associate partner; Tim Koller is a partner in the Denver office; and Werner Rehm is a partner in the New Jersey office.
For a full discussion of market dynamics, see Valuation: Measuring and Managing the Value of Companies, seventh edition (John Wiley & Sons, 2020), by Marc Goedhart, Tim Koller, and David Wessels.