This might be a dumb question… but: CFAI Volume 3 page 99 states - “High inflation rates tend to depress P/E ratios.” For some reason I’m not seeing this. Can someone please elaborate on what they mean? Because I could really see this going either way and I just want to wrap my head around what the CFAI thinks. (PS: I’m pretty sure we had this same discussion last year on the LII board…"
unlike low inflation periods when P/E ratios tend to be higher because there is either the potential for or actual economic growth (g) occurring, the P/E ratio in HIGH inflation environments is lower due to the erosion of real earning growth (especially for firms that cannot pass higher cost along) P/E = (D/E)/r-g
I see that, but are we going to move under the assumption that the erosion in earnings growth has more effect than the actual increase in price? Thinking about it simply: With inflation prices rise. Thus “P” goes up. If “P” goes up all else equal then “P/E” goes up. My mind is kind of loopy right now so bear with me haha!
CF_AHHHHHHHHH Wrote: ------------------------------------------------------- > > Thinking about it simply: With inflation prices > rise. Thus “P” goes up. If “P” goes up all else > equal then “P/E” goes up. > don’t confuse the price of the widget a company sells for “P” the price of the stock. just think about this simply… we observe that S&P has something like a historic average P/E ratio of around 15, that is because the market is willing to pay 15x the average company earning for a claim on those earning during “average times”. When the market is optimistic then the ratio goes up such as the dot com boom (this is where the academics like to try an attribute the optimism with quantifiable expectation of the market with factors having to do with things like growth, inflation, earning, taxes, revenues etc etc). When the market is pessimistic about the future then they are willing to pay less for the future cash flow then average. hence when inflation is HIGH pessimism reigns (due to slower growth expectations, capital value destruction, etc etc) and when inflation is “low” then the market tends to perceive that positively (assuming growth potential) and is willing to pay more for future cash flows. there’s a whole other argument from the perspective of the NPV of your future expected cash flows and the rate that they are discounted, but that is not necessary to get this point.
ahhh ok, I like thinking of it in terms of optimism and pessimism that makes way more sense logically. Thanks Char-Lee