Inflation affects equity prices in many ways. Most importantly, investors are willing to pay less for a certain level of earnings when inflation is low and when inflation is low (and expected to remain so).
- Inflation occurs when the purchasing power of a currency declines over time, with the effect of rising price levels.
- Companies pass on rising costs of production to their customers, making stocks a very good hedge against inflation in general.
- Investors’ expectations are also modified by inflation projections, with higher inflation leading to higher anticipated returns.
- When inflation is high, the P/E ratio decreases because earnings, in the denominator, grow more quickly than the share price.
P/E Ratio Review
Let’s review two concepts involved: the price-to-earnings (P/E) ratio and inflation. The P/E ratio is a valuation measure that shows how much investors are willing to pay for a company’s earnings. For example, if a stock is priced at $50 and earnings per share is $2, the P/E ratio is 25 ($50/$2). This shows that investors are willing to pay 25 times the company’s earnings for a single share. Inflation is a measure of the rate of price increase in the economy.
Stable and moderate inflation means high potential for sustained economic expansion. Modest inflation usually means that the central bank will not raise interest rates to slow economic growth. when inflation And The lower the interest rates, the greater the opportunity for higher real income growth, an increase in the amount people pay for a company’s earnings. The more people are willing to pay, the higher the P/E.
When inflation levels are stable and moderate, investors are less likely to expect higher market returns. Conversely, expectations rise when inflation is high. When inflation rises, so do prices in the economy, leading investors to require a higher rate of return to maintain their purchasing power.
If investors demand a higher rate of return, the P/E ratio will fall. Historically, the lower the P/E, the higher the return. When you pay a lower P/E, you are paying less for more income and as income increases, the return you receive is higher. In periods of low inflation, the returns sought by investors are low and the P/E is high. The higher the P/E, the higher the cost of earnings, which lowers your expectations of strong returns.
In times of low inflation, the quality of earnings is considered high. It refers to the amount of earnings that can be attributed to actual growth in the company and not to external factors such as inflation.
For example, let’s say inflation is 10% per year (which is higher), and a company buys a widget for $100. In a year, the company would be able to sell the same widget for at least $110 due to inflation. Since its cost remains $100 for the widget, it appears to have increased its profit margin, when in fact the growth is doing all the inflation. In general, investors are more willing to pay a premium or higher multiplier for real growth than for artificial growth due to inflation.
Inflation and Stock Returns
Examining historical return data during periods of high and low inflation can provide some clarity for investors. Several studies have looked at the effect of inflation on stock returns.
Unfortunately, these studies have produced conflicting results when several factors are taken into account, namely geography and time period. Most studies conclude that expected inflation can affect stocks either positively or negatively, depending on the investor’s ability to hedge and the government’s monetary policy.
Unexpected inflation showed more conclusive findings, particularly during economic contractions having a stronger positive correlation to stock returns, indicating that the timing of the economic cycle is particularly useful for investors to estimate the effect on stock returns. is important. This correlation is also thought to stem from the fact that unpredictable inflation brings new information about future prices. Similarly, greater volatility of stock movements was correlated with higher inflation rates.
Inflation above or below this range indicates a US macroeconomic environment with larger issues that have different effects on stocks. Perhaps more important than actual returns is the volatility of returns that cause inflation and knowing how to invest in that environment.
History has shown that investors understand this phenomenon and take inflation into account when valuing stocks. When inflation is high, the P/E ratio is low; When inflation is low, the P/E ratio is high.