What is an Inflation-Adjusted Return?

Inflation eats away at the value of every stream of cash flows, including salaries, pension payments and coupon payments. In many cases, the real interest rates on savings accounts are negative. For instance, if a savings account pays 1.5% per year but inflation is 3%, the saver is effectively losing money every year he has the money in the account. However, putting money in a savings account is better than putting it in a coffee can in the backyard, where it will lose the full 3% value every year due to inflation.

Accordingly, it is important to consider the effects of inflation when making an investment that promises to provide a future stream of cash flows. After all, what is worth $1 today may not be worth $1 tomorrow if it is not invested.

How Does an Inflation-Adjusted Return Work?

Let's say John Doe buys Company XYZ stock for $5. A year later, the stock is trading at $6. John's return is 20%. However, inflation during the year was 4%. Using this information and the formula above, John's inflation-adjusted return is:

[(1+.20)/(1+0.04)]-1 = 15.38%

John's return may look like it's 20%, but after you account for the fact that inflation has 'eaten away' at that money, his inflation-adjusted return is only 15.38%.

Why Does an Inflation-Adjusted Return Matter?

An inflation-adjusted return is a rate of return that accounts for inflation's effects. The formula for inflation-adjusted return is:

Inflation-Adjusted Return = [(1+Return)/(1+Inflation Rate)]-1