Inflation and the Stock Market
This is taken from the latest commentary by our friend Chuck Carlson.
"When you look at the things that represent the biggest threats to this market - high energy prices, interest rates, inflation - the one that scares me the most is inflation. Higher inflation can be crippling to stocks. One reason is that higher inflation erodes price/earnings multiples, and lower multiples mean lower stock prices."
"A price/earnings ratio is determined by taking the stock's per-share price and dividing by trailing 12-month earnings per share. Thus, a company with a stock price of $20 per share that has earned $2 per share in earnings over the preceding 12 months has a price/earnings multiple of 10 ($20 divided by $2). Investors oftentimes look at price/earnings ratios not just on trailing earnings but also on forecasted earnings. For example, that same company with a $20 stock price and $2 in earnings over the preceding 12 months is expected to earn $2.50 per share in profits for 2005. Based on that earnings estimate, the stock has a forward price/earnings ratio of 8 ($20 divided by $2.50)."
"One factor that goes into determining appropriate price/earnings multiples for companies is expected growth rate. Higher-growth companies usually receive higher price/earnings ratios. That's because investors generally will pay a premium multiple to buy growth."
"Another important factor in determining price/earnings ratios is inflation. Remember that inflation is the erosion of the value of a dollar. Also remember that investing is all about future expectations. Thus, if you believe the future value of money will be eroded by inflation, you are apt to pay less for that future growth in today's terms. And that means lower price/earnings ratios."
"Here's how the math works: Say you like a stock that you expect to earn $3 per share in 2005. Currently, you are willing to pay 20 times those earnings since you expect solid growth to continue for the firm. A price/earnings ratio of 20 for a company earning $3 per share means a $60 stock price. Now, if you expect inflation to rise, you will not be willing to pay 20 times those $3 in earnings since that $3 in earnings will be worth less with higher inflation. Thus, you knock down the price/earnings ratio to 16 to reflect inflation. What does knocking down the price/earnings multiple from 20 to 16 do to the stock price? It falls from $60 to $48."
"Of course, perhaps you don't believe inflation will be a problem for this market. Still, I think it makes perfect sense to have stocks in a portfolio that represent inflation hedges. Stocks that should hold up reasonably well in an inflationary environment are those that have pricing power, i.e., the ability to raise prices."
"One company that has demonstrated the ability to hike prices is Procter & Gamble (NYSE: PG). The firm's profits in the latest quarter were decent, and I would expect record results this year. I own Procter & Gamble and would look for these shares to at least track the overall market."
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"When you look at the things that represent the biggest threats to this market - high energy prices, interest rates, inflation - the one that scares me the most is inflation. Higher inflation can be crippling to stocks. One reason is that higher inflation erodes price/earnings multiples, and lower multiples mean lower stock prices."
"A price/earnings ratio is determined by taking the stock's per-share price and dividing by trailing 12-month earnings per share. Thus, a company with a stock price of $20 per share that has earned $2 per share in earnings over the preceding 12 months has a price/earnings multiple of 10 ($20 divided by $2). Investors oftentimes look at price/earnings ratios not just on trailing earnings but also on forecasted earnings. For example, that same company with a $20 stock price and $2 in earnings over the preceding 12 months is expected to earn $2.50 per share in profits for 2005. Based on that earnings estimate, the stock has a forward price/earnings ratio of 8 ($20 divided by $2.50)."
"One factor that goes into determining appropriate price/earnings multiples for companies is expected growth rate. Higher-growth companies usually receive higher price/earnings ratios. That's because investors generally will pay a premium multiple to buy growth."
"Another important factor in determining price/earnings ratios is inflation. Remember that inflation is the erosion of the value of a dollar. Also remember that investing is all about future expectations. Thus, if you believe the future value of money will be eroded by inflation, you are apt to pay less for that future growth in today's terms. And that means lower price/earnings ratios."
"Here's how the math works: Say you like a stock that you expect to earn $3 per share in 2005. Currently, you are willing to pay 20 times those earnings since you expect solid growth to continue for the firm. A price/earnings ratio of 20 for a company earning $3 per share means a $60 stock price. Now, if you expect inflation to rise, you will not be willing to pay 20 times those $3 in earnings since that $3 in earnings will be worth less with higher inflation. Thus, you knock down the price/earnings ratio to 16 to reflect inflation. What does knocking down the price/earnings multiple from 20 to 16 do to the stock price? It falls from $60 to $48."
"Of course, perhaps you don't believe inflation will be a problem for this market. Still, I think it makes perfect sense to have stocks in a portfolio that represent inflation hedges. Stocks that should hold up reasonably well in an inflationary environment are those that have pricing power, i.e., the ability to raise prices."
"One company that has demonstrated the ability to hike prices is Procter & Gamble (NYSE: PG). The firm's profits in the latest quarter were decent, and I would expect record results this year. I own Procter & Gamble and would look for these shares to at least track the overall market."
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posted by Bob Moser at
3:44 PM
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