What it is:
savings account pays 1.5% per but inflation is 3%, the saver is effectively losing 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 lose the full 3% value every year due to inflation.
Accordingly, it is important to consider the effects of inflation when making an 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 it works/Example:
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%.