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.