Tuesday 9 February 2010

Inflation and Corporate Earnings

How inflation can destroy shareholder value in the latest McKinsey Quarterly (free registration required to get access) brilliantly illustrates with a simple easy-to-follow example how inflation can surreptitiously erode real profitability in a company and thereby undermine its shares. The point made is essentially that when inflation jumps up, it is not enough for earnings to rise by the inflation amount. Unless cash flows do too, the company and the shareholder lose ground. Earnings must appear to rise by a much greater amount just to keep pace (it is worth pondering that if that were to happen, there would be public outcry about corporations gouging ordinary people, whereas they would actually be losing ground). The driver is that depreciation, a non-cash flow item, does not rise as fast as inflation and this skews profitability ratios and hides loss of real earnings.

The piece also includes a neat graph showing how returns on invested capital during the high inflation 1970s did not move outside their remarkably constant band of 8 to 11%, whereas they should have gone up to 25 to 30% to maintain real profitability during that decade. Accordingly, stocks did very poorly.

The lesson of inflation during the 1970s is worth noting. If inflation reignites, stocks / equities are not likely a good place to be.

1 comment:

larry macdonald said...

Good reminder about inflation and stocks in the 1970s. Inflation leads to stop-go monetary policies; the resulting volatility makes it hard for bsuiensses to plan. It also leads to higher lending rates.

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