{"id":1153,"date":"2024-07-12T13:46:40","date_gmt":"2024-07-12T13:46:40","guid":{"rendered":"https:\/\/cedcapital.in\/?p=1153"},"modified":"2024-07-12T13:46:40","modified_gmt":"2024-07-12T13:46:40","slug":"understanding-impact-of-inflation-on-intrinsic-values","status":"publish","type":"post","link":"https:\/\/cedcapital.in\/?p=1153","title":{"rendered":"Understanding impact of inflation on intrinsic values"},"content":{"rendered":"

While exact causes and future trajectory of inflation are neither easy nor interesting topics to discuss, the impact inflation has on businesses, valuations and investment opportunities is real and therefore deserves your investment attention<\/strong>.\u00a0<\/span><\/p>\n

Intrinsic value of a business is present value of its future free-cash-flows (cash profits less investments) discounted at an expected reasonable rate of return. Inflation can adversely affect all the three elements of this value equation<\/strong> \u2013 (1) profits, (2) investments in working capital & fixed assets and (3) expected reasonable rate of return (aka<\/em> cost of capital).<\/span><\/p>\n

Profits<\/strong> \u2013 When revenues fail to increase as fast as costs during inflation, profitability suffers. There are two antidotes to this\u2013 (a) raise prices, and\/or (b) control costs. There are many nuances to each of them.<\/span><\/p>\n

Companies that sell unsubstitutable necessities such as staples, utilities etc. can raise prices without material effect on volumes. Inflation raises output prices for commodity producing companies (steel, copper, aluminium, oil etc.), but the benefits are temporary due to cyclicity \u2013 higher prices reduce demand and\/or attract new supply that cool prices. For lenders, interest rates on loans are reset faster than cost of deposits and supports margins. Industries with low spare capacity can raise prices in near term without materially affecting volumes. On the other side, often regulatory caps on pricing can become a deterrent. If end consumers are seeing strain on their budgets, they will try to delay, substitute or downtrend. However, companies serving higher income consumers may be hit less.<\/span><\/p>\n

On cost side, companies with high operating margins<\/em> can maintain absolute profits without large increase in output prices during inflation. Illustration:<\/em> if revenue is 100, operating cost is 30, then operating profit is 70 (and operating margin 70%). If costs rise by 10% to 33, just a 3% rise in sales price to 103 can protect absolute operating profits of 70. Whereas if the operating margins are 30%, a 7% rise in sales prices will be needed.\u00a0 Continuing on costs, companies with high operating leverage (high fixed costs) can see rise in margins with rise in volumes (rise in fixed costs is slower than rise in volumes and improves margins). Lastly, a lower cost player can breakeven when others in the industry bleed and can get stronger as competition dwindle.<\/span><\/p>\n

Finally, if inflation leads to rise in interest rates or currency depreciation, companies with high debt or imports can see sharp rise in their interest and forex cost, that can further hurt profits.<\/span><\/p>\n

Investments<\/strong> \u2013 Working capital and capital expenditure (capex) rise with inflation. Rising input prices increase investments in inventory, and rising output prices increase receivables. Some of this is negated by rise in payables. Dominant companies who can keep low inventories, receive dues faster from customers and delay payment to vendors can keep working capital low. Capex heavy businesses are worst hit during inflation. Maintenance or new capex rise in line with inflation. The rise has to be paid out of profits and this reduces free cash that can distributed to shareholders. Capex and working capital light businesses are best saved during inflation. Services are generally less investment intensive than goods. Companies where large capex is already done will also be less affected by inflation.<\/span><\/p>\n

Discount Rate<\/strong>: Central banks usually raise interest rates to control inflation. This raises the hurdle rate that risky investments like equities should deliver. A higher discount rate reduces present value of future cashflows. There is no running away from this for any<\/em> company, but loss making companies with back ended cashflows are hit more. Higher discount rates should make us wary of paying high multiples even for strong companies. Keeping other things constant, what was deemed fair at 30x earnings during low inflationary period can become expensive during high inflation.<\/span><\/p>\n

For a given company, the net effect of inflation on all three variables – profits, investments and discount rate – need to be studied together to understand its investment merit.<\/strong> High points on profitability and\/or investments may be nullified by low points due to high valuations. Moreover, short term effects need to be separated from longer term effects. Pricing tailwinds for many commodity producers may be cyclical. Stronger companies may sacrifice margins in near term to capture market share from weaker ones. In short, assessing impact of inflation on intrinsic value is little messy<\/strong> and we need to err on the side of caution. This means accepting that the sub set of companies whose intrinsic values may rise during inflation is very small.<\/span><\/p>\n","protected":false},"excerpt":{"rendered":"

While exact causes and future trajectory of inflation are neither easy nor interesting topics to discuss, the impact inflation has on businesses, valuations and investment opportunities is real and therefore deserves your investment attention.\u00a0 Intrinsic value of a business is present value of its future free-cash-flows (cash profits less investments) discounted at an expected reasonable […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[15,4],"tags":[],"class_list":["post-1153","post","type-post","status-publish","format-standard","hentry","category-business-analysis","category-macroeconomics"],"jetpack_featured_media_url":"","jetpack_sharing_enabled":true,"_links":{"self":[{"href":"https:\/\/cedcapital.in\/index.php?rest_route=\/wp\/v2\/posts\/1153","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/cedcapital.in\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/cedcapital.in\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/cedcapital.in\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/cedcapital.in\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=1153"}],"version-history":[{"count":3,"href":"https:\/\/cedcapital.in\/index.php?rest_route=\/wp\/v2\/posts\/1153\/revisions"}],"predecessor-version":[{"id":1156,"href":"https:\/\/cedcapital.in\/index.php?rest_route=\/wp\/v2\/posts\/1153\/revisions\/1156"}],"wp:attachment":[{"href":"https:\/\/cedcapital.in\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=1153"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/cedcapital.in\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=1153"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/cedcapital.in\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=1153"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}