Saturday, June 14, 2008

How does inflation affect stock owners?

Today's business news media is rife with articles suggesting inflation is here to stay. Were that to happen, what does it mean for equity holders? Upon first reflection, it would seem that in inflationary times, companies can charge more for their products, and thus should have a natural hedge against inflation. Unfortunately, companies in such times are forced to invest their profits in the companies JUST to keep returns at ordinary levels, resulting in real costs to equity holders.

Consider a numerical example for a given company. For simplicity, we will consider total assets (e.g. A/R, inventory, fixed assets) at $1000, and annual sales at $2000/year. Assuming profit margins of 5%, this level of annual sales translates to $100 in profits.

At zero inflation (to keep the example simple), that profit of $100 can pay shareholders, or can be re-invested in the company to generate further returns the following year.

At 10% inflation, presumably sales increase to $2200 / year. Margins stay at 5% since costs increase as well, resulting in profits of $110. Sounds fine, right? Profits have increased along with inflation, resulting in no loss for the equity holder. Unfortunately, this isn't the end of the story.

We've implicitly assumed asset turnover (sales / assets) will increase with inflation. But there is no reason to believe this. Inflationary increases in dollar amounts for assets such as A/R, inventories, and fixed assets will be required to service these inflationary increases in sales. We had assets at $1000. With our 10% inflation, asset requirements become $1100, eating up almost all of the $110 in profits. What's the value of a company that needs to re-invest all its profits just to maintain its earnings? Very little.

The numbers were made up, but the principle of this argument will persist no matter what numbers are chosen. Inflation eats up profits. If inflation is high, equity values will suffer.

5 comments:

John said...

I'm not sure I follow what your "asset requirement" $1100 represents. If I look at it from the cashflow perspective, the bit related to fixed assets that will erode the free cashflow is the inflationary increase in maintenance expenditure.

Saj Karsan said...

Hi John,

It's not just maintenance expenditures for fixed assets that get affected. All assets get affected by inflation (e.g. inventory, A/R etc), so free cash gets swallowed up by required increases in working capital requirements along with other assets.

John said...

Saj,

Let's consider an example. Say, I'm a baker. I rent a shop front, bake breads and sell them. My fixed asset will be my $5000 oven which has a 10 years usable life and needs annual service costing $100. Now inflation suddenly gets to 200%. (Yes, 200%. my baker shop is in some Africa country.) What changes? Rent, cost of flour, utility bills. But the inflation doesn't suddenly force me to spend $10,000 (i.e. $5000 x 200%) on an new oven (what is your original post implied). Only the annual service cost grows to $200.

Saj Karsan said...

Hi John,

In your example, you're right you don't need to replace the oven right away. But the article is not focusing on fixed assets (which I agree will have some delays before requiring replacing), but rather total assets.

So for your example, let's say you have annual sales of $10,000 for your $5000 of fixed assets (fairly reasonable), and make a profit margin of 10%, so $1000 in profits. When 100% inflation hits (I think you mean 100%, not 200%?), your profits become $2000.

But you have other assets, let's say of $2000, consisting of A/R and inventory. Your baker's customers are large companies that pay late, and so your A/R jumps from $1000 to $2000 (thanks to 100% inflation), which is about 36 days outstanding, not far-fetched. Furthermore, your customers like selection, and still need that selection to maintain your sales level, so your inventory jumps from $1000 to $2000 as well (thanks to 100% inflation).

Basically, your $2000 of profit, although it is "profit", has been eaten up by A/R and inventory, so no free cash flow despite the semblance of higher profits.

You're barely getting by as it is, just wait until you actually DO have to replace that oven!

nice said...

NIce article but I am not sure I follow since I read company stocks that deal with commodities, FCX for example, actually get an advantage with inflation even if it is only nominal and not real. Their earnings and dividends thus go up, even though part of that is really due to inflation and not real increase in production, yes? At least this is what I have seen in this market recently (now it is October, 2009).

Thanks.

Follow by Email