Depreciation in shareholder value is the cost of inflation. If one factors in the rate of inflation into the earnings per share and the market capitalization, then the real value of the shareholder can be assessed in more realistic terms. The dynamics of financial markets are such that, as rate of inflation goes up, the volatility of the share market also increases. The shareholder can thus book profits to mitigate the effects of inflation.

I think the numerical example is flawed. In the “losing ground” scenario, costs (sales minus EBITDA) increase faster than inflation. In any settting, high inflation or not, if costs increase faster than prices, it is not a surprise that value is lost. The example could be better structured to illustrate the fact that price increases should match the increase in “replacement” costs, rather than “accounting” costs.

Inflation can also destroy value of the citizens as it was in Russia in the 1990s. Huge injections of money into the economy combined with a decline in production (in 1992 GDP growth was -18%) caused inflation to peak at about 2600% in 1992. That utterly destroyed the financial savings of most people.

That shows the flaw in the monetary system in which money can be created out of thin air and then exchanged on some goods and services.

In Australia, our Reserve Bank successfully manages inflation by regulating the interest rates. Small regular adjustments are not too painful for businesses, but certainly sufficient to make managers aware of inflationary dangers. The real killers are the giant leaps in transport costs, leasing, and wages, plus, of course, the ever-increasing cost of replacement stock. Projecting future earning is difficult, but one thing is for sure, do not underestimate the inflation factor.

The demonstration is based on the assumption from a footnote that while CAPEX increase at inflation rate, there is a lag in the increase in depreciation, as assets are depreciated first in the next year after acquisition.

There are three cases. Case 1 has no inflation. Case 2 EBITA is growing at inflation rate. Case 3 EBITDA is growing at inflation rate.

Case 2 which supposedly proves the destruction of shareholder value implies actually that operational expenses are growing faster than inflation, i.e., 17.4% in Y1, 16.9% in Y2 and so on. This is evident as EBITA is growing at inflation rate and depreciation is growing slower.

The article proves the obvious truth that when costs rise faster than revenues, shareholder value is destroyed.

As working in a country that experienced high levels of inflation, I would actually argue that sometimes inflation has a positive effect on shareholder value. An attentive reader has already correctly indicated in a comment the reduction in real cost of debt financing. Beside this, due to sticky wages operational expenses can increase slower than inflation especially in labor intensive industries. Companies might also experience growth in sales volumes when competitors increase their prices too fast. Thus inflation might create opportunities for economies of scale. Nevertheless, high inflation rates remain of course undesirable.

Unfortunately, the positive effects of inflation in the monetary liabilities of the balance sheet do not usually compensate for the negative effects it has in the assets side, such as the loss of value of cash and receivables, and deviation of calculated depreciation.

As the article demonstrates, it is difficult for companies to counterweight the effects of inflation. It is not sufficient to pass the full cost of inflation to customers, but it is also necessary to increase earnings at a rate higher than inflation in order to compensate for lower depreciation. Depreciation during inflationary periods is lower than the cost of replacement of depreciable assets and also offers less tax shelter. To maintain the generation of cash flow, it is necessary to achieve rates of earnings growth above inflation, and for some levels this can be a daunting task. It might entail pursuing increases in market share which is mathematically impossible if all the market participants pretend to do it at the same time.

Also, the higher cost of capital in real and nominal terms reduce the present value of expected future cash flows and the calculated value of share prices. Financial markets liquidity, which might be present during inflationary periods, might not be enough to increase demand of shares and avoid poor stock market performance unless liquidity is also accompanied with a substantial appetite of investors for risk.

@ Neerav Joshipura: Indian IT companies have grown more than 50% during the duration you mentioned and hence created the shareholder value.

Inflation, like fire, destroys value. We know from the analogy that when the heat is on, fire is likely to break out. So it is with inflation and its corollary in the economic cycle, deflation. We talk of the market getting too hot for our liking, that we are liable to burn our fingers.

If we are talking of fires and we are talking of heat, then we need to talk about the fuel, namely, the exigencies of money supply. The way money flows in the market and gets polarized, and as a result sometimes moves out of the market, and also the manner in which money utilizes resources, which is to say as brigands or as shareholders interested in creating enduring value, adds fuel to a fire which, in some form or other, is already raging.

The only way to beat inflation is, of course, to put out the fire! Not an easy task, yet possibly the only strategy for a business. You might want to explore new markets which may keep you out of the flames. But if you are selling floor polish and raising prices is your only way to beat inflation, the jury is going to be forever out on the question whether you have a chance in a thousand to determine the course of your own business. As an economist you may want to look at ensuring that money doesn’t get polarized, that national debt is contained and that the glut of money in the market, which is not tied to productive work, is mopped up. Inflation would become a lesser problem and you would again be in the driving seat in managing your business.

Who on earth is worried about inflation now? Deflation appears to be the greater threat.

Having lived and worked through the high-inflationary early seventies and having made the decisions to borrow, I agree wholeheartedly with the article’s thesis and with the comments regarding building a nominal interest rate (or ROI expectation) that anticipates expected inflation. Obviously as inflation begins to rise, lenders from the central bank and down are building inflation into their rates—this is simply the market place working. However, I do feel that our central banks, at least in North America, Australia, and Europe have become quite sophisticated in their approach to monetary policy. Granted, matters got out of hand, but I feel we are now at the beginning of a long-term, more positive trend and we will see “benign” inflation of around 2% return to much of our world.

The report is a very interesting read. I think we should look at inflation as an opportunity as well as challenge. Inflation forces us to improve our operations. It forces us to manage inventories better, manage our costs better, and to reduce the waste in the whole system. This becomes necessary to maintain profitability. These learnings during times of inflation benefit organisations in the long term.

How inflation can destroy shareholder value, or more to the point, does inflation destroy shareholder value? As one commentator suggested, it’s probably deflation that has a more immediate impact but ignoring that for the present and to answer the question (putting my best economist’s hat on) ‘it depends’.

The fallacy of composition suggests that whilst one may profit in isolation in the short term, when all others catch up the outlying entity is simply brought back to the mean.

Inflation can be viewed this way—be it one company, industry group or in the macro sense country, the benefits of rising prices through limited supply or policy only remain so as long as the others don’t catch up.

So, ignoring the short-term (illusory) benefits of inflation on the single entity and considering its impact when pervasive and entrenched across the community, the result for shareholders are as for those of that community in general, wherever that may be.

For all the traditional reasons of misallocation of investment capital to diminishment of the savings incentive, unchecked inflation is a scourge that disrupts the normal social and economic progress of communities and therefore is indeed detrimental to shareholder value.

I agree with the effects of inflation in stock values. But is a high inflation time period the proper scenario? I think an important point is missing in the paper. Is the inflation generated by a external shock (lack of supply) of increasing oil prices as in the 70s and 80s, or is the inflation a result of an excessive monetary supply as we are facing today? Or, in other words, is the inflation structural or monetary? In this second source of inflation, the liquidly excess will continue to push up the value of financial assets and equity values as well. The asset reflection trade will still be present in the market until the Fed begins to tighten monetary policy. So, I think in this case inflation will be just a financial topic and hardly a real economic problem (such as excess capacity nearly in every industry, no increase in credit, no increase in consumption, etcetera).

From macroeconomic standpoint, inflation is the most absurd and regressive of all taxes. Nobody collects it and every body pays it. The more poor you are, the more you pay. It’s “empooring” power is superb. Since the rise and fall of the Roman Empire through Argentina’s modern experience, we can confirm this fact. From the shareholders’ standpoint, boards and managers need to be very prudent but aggressive as well in order to transform the problem into an opportunity. This is the very essence of a manager (transforming problems in opportunities) since Peter Drucker thought and wrote about administration, reinventing it as a science and art, with practice as a must.

It is a certain fact that inflationary environments are likely to have negative consequences to businesses, largely because they have a harder time interpreting price signals that would otherwise reveal changes to supply and demand in relevant markets. However, it is important to note that inflation also erodes the value of debt and savings, so shareholders who fear it would be wise to consider the silver lining possessed by companies that maintain high debt levels.

Furthermore, equity holders would at least see their shares rise in nominal value, which is more than can be said for long-term bondholders. That being said, in the US, Europe, or Canada, it seems highly unlikely that inflation will be allowed to take off; the fiscal situation in western countries might be getting worse, but is nowhere near the levels where that dramatic monetary loosening would be worthwhile for an economy. The past two decades of price stability have taught us that low and stable inflation facilitates both business and savings decisions and would consequently not easily be done away with. Indeed, the news may be suggesting the collapse of America and the need to monetize its debt through inflation, but the truth is that US debt levels will not even approach half those supported by some other developed nations (including Japan) when considered as a ratio of GDP. Inflation of over 4%? I wouldn’t worry about it.

Currently we are not seeing inflation. Commodities, wages, real estate, and capital are stable (or declining). We learned to manage in inflation (even stag-flation) during the 80s. Double-digit inflation is challenging, but can be a real opportunity for skilled managers. Inflation can actually reduce the budget deficit. The real fear is deflation.

I believe there are two aspects with inflation that are not necessarily linked in timing: shareholder return and company performance. We in Argentina have been (and unfortunately still are) accustomed to manage our companies in an inflationary environment. For investors in Argentina, buying shares of publicly traded companies has been a shelter against inflation in the medium term (2 years average; the value of shares has followed or even beaten inflation, in local currency and in hard currency in such period).

With respect to companies, I studied in the US during the 80s and despite the US having had inflation in previous years, in general US managers didn’t understand how to deal with such, unlike in Argentina that managers had to deal and anticipate it (3-digit inflation rates) or their companies would dissapear. Dealing with inflation is not only a matter of how to maintain operating margins in real terms, but also how to deal with unions, manage inventories, receivables and suppliers, fx positions (which usually move with inflation or fuels additional inflation because of import costs), and short term investments, among others. For example, supermarkets in inflationary times used to make money not on operations (usually it doesn’t matter so much efficiencies in sales/m2) but on how they invest their negative float originated in selling cash and paying suppliers 15/30 or more days. In Argentina, in inflationary times CFOs were the most important people in companies, and in noninflationary times they become more commodities, and marketing and operations managers become crucial. I believe that this time US managers will be better educated to deal with inflation and investors will realize that owning shares in a well-managed company will protect them against inflation.

The authors have brilliantly emphasized a problem frequently neglected by many executives. Referring to my professional experience in the telecommunication market, I can say that players, especially in western European countries, have to be really worried about that. The market is stagnating and for sure can’t grow at the same level of inflation. I think that especially players in B2B markets will have some difficulty in translating the problem to their clients, and thereby if the foreseen inflation trend will materialize they will meet tough times.

I noticed that on the history chart there is no clear correlation between inflation and ROIC. Perhaps a correlation analysis could help make the evidence.

The problem identified is one of accounting, not true shareholder value destruction. Depreciation is based on historic cost assets and therefore does a poor job of reflecting the true economic cost from depletion of assets, especially when inflation is high. An investor focused on cash-flow rather than accounting earnings would ignore the depreciation charge and focus on capex. This would show cash-flows growing inline with sales even in a high inflation environment (provided cost increases are passed through to prices, as assumed in the article). The reason the exhibits in the article do not show this is that the authors have decided to keep EBITA (including the non-cash depreciation charge) in proportion to sales rather than EBITDA. Their conclusions then stem largely from this decision and is little more than a reflection of the depreciation issue above. One final point I would make is that companies financed with debt will see a benefit in terms of their real cost of capital as inflation increases and therefore their valuation will benefit from higher inflation.

A very interesting article, but the graph seems to negate the thrust of the article. The graph showed that there was no significant difference in terms of ROIC during the great inflation of the 70s over time. This is due mostly because, conditions and scenarios raised in the article are likely to have political consequences where policy changes rebalance the issue. Great inflation historically has been caused—in the major industrial powers that is—by external forces where the country is reactive: Germany in the 20s from WWI war reparations; ours in the 70s by the oil embargoes and price increases. Finally, the reason for the massive increases in debt is to stave off deflation from the US and global economy. McKinsey might want to come up with a counter article about how companies might understand how deflation affects their earnings and other financial gearing so there is an up- and down-side argument.

The effects of expanded monetary policy, as we are seeing, may be devastating to shareholder value as driven by earnings. The central factor is whether the administration and the Fed can take appropriate steps to curb money supplies. As it is, yup, inflation is coming.

I wrote a paper showing a strong relationship between interest rates (inflation) and PE ratio, highlighting the damaging effects of inflation. I thought the cause was different than you presented. I concluded that risk premiums are proportionate to the risk-free rate, not a fixed premium. The result is that risk premiums rise and fall with inflation, causing PE ratios to rise and fall as well. I called it the Risk Premium Factor Valuation Model. The paper can be found at: http://ssrn.com/abstract=1445445. The model holds for the entire period of my available dataset from 1960-present. Perhaps your argument is part of the explanation for my observations.

I must say that Mark, Tim, and David’s article is interesting, insightful, and thought-provoking. From my experience of advising clients in the various sectors within the East African region of Africa, it has always been amazing and surprising to see just how few senior executives ever get to factor in the inflation component in their pricing and decision making process. This has in turn ended up creating imaginary gains or losses, depending on a company’s situation.

In East Africa, the manufacturing sector and the import businesses seem to be more prone to the effects of inflation. However, to counter the impact of inflation on our valutions, our corporate finance team ensures that it always factors in the country’s inflation component into all the valuations that we carry out. With this factored in, the results and range of values we get become more realistic than when one just ignores the important role and influnece of inflation.

Excellent Analysis; Franco Modigliani’s reference brings back memories of University days; having gotten a bit wiser and beyond academic analysis of ROIC, I am quickly taken on a historical, magical carpet ride through America and see these two giant billboards appear before my very eyes. The first one says (and I am paraphrasing as I was going by at very high speed): “If The People understood the injustice of our money and banking system, there would be a revolution before morning”. The second billboard said: “The game is rigged, you’ve been bamboozled, hoodwinked, you’ve been had”...ahhh if we could only learn from history.

Excellent analysis! Being part of IT industry and offshoring / outsouring waves, I applied the logic to Indian IT companies. Using above analysis, how does one explain the fact that the investor values of Indian IT companies have increased in spite of near double-digit average inflation and reduction in hourly labor rates for the last 15 years? Increased volume of business could be one reason, but not a complete explanation.

I found your report very interesting as it creates awareness for the economic threat of inflation as well as it’s role in determining investments in assets, which are more capable to be able to pass on its cost to the market. Nonetheless, your model raises some significant questions:

1) You compare ROIC to the CPI. Isn’t this to some extent misleading as we mostly speak about assets as machinery, whose price fluctuations are not comparable to those in the entire CPI basket?

2) If your theory was correct, there should be in any case a cyclical behaviour in ROIC. Were FCF not able to grow at the pace of inflation (for the companies assets in question), but inflated assets being acquired, then those should lead to a drop of ROIC when inflation drops, as assets are being depreciated at the inflated rate.

I am looking forward to your opinion.

Goedhart, Koller, and Wessels provided an excellent and commendable summary. Their cash flow analysis was a pleasant exercise. Yet I think there are a couple of other facets worth exploring. One is related to cash flow and the other to direct equity values.

Actual investors, as opposed to the “technical” species of speculator, compare various measures and ratios including current assets to current liabilities. Cash rich companies hold an asset that is directly depreciated as the money inflates. Companies have long adopted “just in time” for inventories and materials or product delivery, perhaps they need to explore broader options to devise “just in time” schemes for idle cash. Companies may then minimize the sting of inflation by working their reserves more diligently.

As for equity, I like to look at my equity per share in relation to my earnings per share. Is it worth investing $x in company XYZ because that equity stake has earned sufficient profitability that it is worth more to me than letting a bank use it in order to pay me interest on those funds? In monetary inflationary times, however, the old capital is muddied by values in plant and equipment, for instance, that may be experiencing a compensating rise in money values. If the corporate office building rises in real estate value because the $10 million previous value would cost someone else $20 million to make the same building elsewhere, then my equity in the company with a $10 million office has just risen when property values reflect a $20 million current worth. Current real estate valuations are in trouble, but the future comes back to this simple fact, if the dollar is worth half as much, it will take twice as many to buy a thing of comparable value. Similarly, that $100 thousand dollar specialty machine may now cost $200 thousand in inflated money, so companies start shopping good used equipment. That means my depreciated machine may have appreciated in the used equipment market, raising my corporate equity.

Finally, there are productivity innovations to keep in mind. Substitutions and innovations become especially important. Years ago when air conditioned cars were new, adding a $200 machine, while tacking $500 to the price, turned $500 gross profit (in the days of $3,000 cars) sale into an $800 gain. There are limits to squeezing costs and prices without adverse sales and profit effects, but the “new and improved” product permits new and improved pricing and profit margins. The maker of bull whips then restyled and resized his product to save on labor and materials and so starts selling the smaller and lighter horse whip. Product re-engineering based on comparative value fluctuations of alternate materials continues to have merit during inflationary periods.

I agree with your comments in the article. Inflation above a targeted band increases uncertainty and thereby lowers real values. More risk enters the business model. We strive to measure inflation by our various price indices, the most recognized being the US CPI. But these are imperfect measures of the real world. There was a study published about a year ago that stated if the federal government had not replaced the price of a house with the rental of a house in the 1980s, the CPI would have been over 6% in 2006-08. It would have been interesting to see how the Federal Reserve would have responded to that development. Thus, it is possible that we might not “see” the impact of the expected inflation. It may come in more disguised forms. These disguised forms will be just as destructive to value as inflation was in the early 1980 period.