Nominal Discounting Preferred: Practical Reasons Explained

Imagine you are planning for your future, maybe saving up to buy a house in a few years. You estimate the house will cost $300,000 in five years. This $300,000 is a nominal amount, meaning it’s expressed in the dollars you expect to use in five years. It already reflects any anticipated price increases, or inflation, that might happen between now and then.

Now, to figure out how much you need to save today, you need to consider the time value of money. Money today is worth more than the same amount of money in the future because you could invest it and earn a return. This is where discounting comes in. You use a discount rate, which is essentially the rate of return you could expect to earn on your investments, to bring that future $300,000 back to its present value today.

The question then becomes, should we discount that future nominal amount using a nominal discount rate, or should we try to adjust everything for inflation and use real values?

Let’s break down the difference. Nominal cash flows, like that $300,000 house price, are stated in the actual dollars expected at each point in time. They include the effect of inflation. A nominal discount rate also includes an expectation of inflation. Think of it like this: if you expect investments to grow at 7% per year, and inflation is expected to be 3%, that 7% is a nominal rate because it accounts for both real growth and inflation.

Real cash flows and real discount rates, on the other hand, attempt to strip out the effect of inflation. A real cash flow would try to express the future value in today’s dollars, essentially removing the expected price increases due to inflation. Similarly, a real discount rate would represent the return an investor requires above and beyond inflation. In our example, if the nominal rate is 7% and inflation is 3%, the real discount rate would be approximately 4%.

While conceptually, discounting real cash flows with a real discount rate seems appealing because it isolates the ‘real’ growth of an investment, in practice, discounting nominal cash flows with a nominal discount rate is generally preferred, and for some very practical reasons.

Firstly, it is simply easier and more straightforward to work with nominal values. Businesses operate in a nominal world. Their revenues are in dollars, their expenses are in dollars, and their financial statements are in dollars. When forecasting future cash flows for a project, it’s much more natural and practical to forecast the actual dollar amounts expected, which inherently include inflation if inflation is expected. Trying to predict and strip out inflation from each future cash flow projection adds an extra layer of complexity and potential error.

Secondly, nominal discount rates are more readily observable and understood. Market interest rates, required returns on equity, and the cost of capital are all typically expressed in nominal terms. These rates already incorporate investors’ expectations about future inflation. It’s easier to find and justify a nominal discount rate based on market data than it is to accurately estimate a real discount rate. Calculating a real discount rate requires explicitly estimating future inflation, which is itself a challenging task and introduces another source of potential error.

Thirdly, using nominal values ensures consistency between cash flows and discount rates. If you forecast nominal cash flows, which reflect expected price increases due to inflation, you should use a discount rate that also reflects inflation expectations. Mixing nominal cash flows with a real discount rate, or vice versa, would be inconsistent and lead to incorrect valuation results. It would be like comparing apples to oranges. You need to ensure you are discounting like for like.

Imagine you are evaluating a project that is expected to generate $100,000 in cash flow next year. If you use a nominal discount rate of 10%, the present value is roughly $90,909. If you incorrectly attempted to use a real discount rate, say 7%, assuming 3% inflation was already removed from the $100,000, you would get a different present value, and likely an incorrect investment decision.

While real analysis can be useful in specific situations, for instance, when analyzing investments in sectors where prices are expected to remain relatively constant or when comparing projects across countries with vastly different inflation rates, the vast majority of financial analysis and investment decisions are made using nominal cash flows and nominal discount rates. This approach is more practical, more consistent with how businesses operate, and more aligned with readily available market data, making it the generally preferred and more reliable method.