How Inflation Can Destroy Shareholder Value
If inflation rises again, companies will have to do more than just match it to keep up—they’ll have to beat it.
February 2010 | by David Delaney
Whatever role low interest rates and high government spending may have played in helping economies to stabilize during the recent global recession, they now have companies, investors, and policy makers alike on the lookout for inflation to come roaring back. Some economists are already warning of a return to the levels of the 1970s, when inflation in the developed countries of Europe and North America hovered at around 10 percent. That’s not uncommon in Latin America and Asia, where emerging economies have seen double-digit inflation for many years.
At first glance, the effects of inflation on a company’s ability to create value might seem negligible. After all, as long as managers can pass increased costs on to the customer, they can keep inflation from eroding shareholder value. Most managers believe that to achieve this goal, they need only ensure that earnings grow at the rate of inflation.
Yet a closer analysis reveals that to fend off inflation’s value-destroying effects, earnings must grow much faster than inflation—a target that companies typically don’t hit, as history shows. In the mid-1970s to the 1980s, for instance, US companies managed to increase their earnings per share at a rate roughly equal to that of inflation, around 10 percent. But to preserve shareholder value, our analysis finds, they would actually have had to increase their earnings growth by around 20 percent. This shortfall was one of the main reasons for poor stock market returns in those years.
Reexamining the Cost of Capital
If management teams could lock in today’s low cost of capital as easily as a home owner locks in a long-term interest rate, investing would be easy. Since they cannot, companies must be particularly careful in assessing a project’s potential value. The best assessment should not only take into account both the real cost of capital and an estimate of inflation. It should also ensure that the same inflation rate is explicitly included in analyses of a project’s cash flow as is used in estimates of cost of capital. The fact is that in general projects that were unattractive in the past do not magically become attractive just because interest rates drop.
This is a crucial point for many companies, particularly those whose various investment teams either don’t interact or don’t understand the varying approaches they employ to estimate a prospective project’s cost of capital and approximate cash flow. As a result, companies sometimes overlook the fact that lower inflation rates should produce lower nominal cash flow forecasts, offsetting a lower discount rate. If a team analyzing an investment updated its cost of capital calculations but not its growth and revenue calculations, its overall assessment of any given project would inevitably overstate the project’s value.
Another critical point often overlooked by companies is that lower real interest rates on government bonds don’t always lead to lower real costs of equity. Indeed, the real cost of equity appears to be more stable than the real risk-free rate, suggesting that while interest rates may decline, investors' demands for higher risk premiums likely offset the effect of interest rate declines on the nominal cost of equity.