Inflation and its effects on Stock Prices

The Effects of Inflation

Inflation: The effectsInflation represents one of the major threats to stock investors, many industries wait for the response of the RBI for tactics of combating inflation

One of the alternatives is to increase interest rates, but then it becomes expensive for the companies to borrow money, their borrowing costs increase and expansion plans are stopped

The globalization of the market may lead to loss of competitiveness of companies that compete in the global arena Since inflation rates are not the same in foreign countries the rise will not be reflected in the prices of foreign goods.

Inflation: The effectsInflation has another negative impact, namely the prices rise but no additional value is added. This means that your money lose purchasing power and as a result you buy less with the money you have than before

Since revenues and earnings of companies rise at the same pace as inflation, their financials are overstated since no additional value is created

When the inflation starts to fall to its normal levels, the overstated earnings and revenues will decline as well. These ups and downs lead to blurring the actual state of value

Inflation : An Analysis

Inflation: An AnalysisTo analyze the effects of inflation on valuation process, analysts try to determine what part of inflation flows through to a firms earnings

A full-flow-through firm has earnings that fully reflect inflation. Thus any inflation cost increases are passed on to consumers

By discounting the stream of inflation growing earning at the required rate (r), we find that intrinsic value of a firm will be Po=E1/r-I

And if the pass through rate of inflation to consumers is x thanPo=E1/{(r-I)+(1-x)*I}Where - E1- earnings of next year (this year earnings multiplied by inflation Eo*I)Po-value of the firmr- Required rate of returnI-inflation rate

Inflation analysis: ExampleIf we take an example and assume that there are two companies A (with complete passing inflation to consumers) and B (with inflation passing rate of 40%) , required rate of return (r) is 6% and Inflation is 4% and earnings is10 for both the companies.

The value of company A is: 10/ (.06-.04) = 500 Rs.

The value of company B is: 10/ ((.06-.04)+((1-.4)*.04))= 227.27 Rs.

So we can say that though stocks provide a hedge against inflation but only when it can pass that inflation to consumers and reflect it in earnings and two conclusions can be derived-

Stocks cannot mostly pass whole inflation to consumers due to increase in competition and due to presence in various countries because there can be inflation in one country but may be not in another country which decreases its value

With the increase in inflation cost of borrowing is generally increased due to increase in interest rates as a result companies have to stop their expansion plans and their growth is reduced which reduces their valuation

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