Does higher inflation increase or decrease P/E ratio? and what formula can be used to demonstrate it?
P/E and inflation are inversely related. The reason I have seen given is that in period of high inflation investors are more scared and require a higher rate of return, hence lower P/E. I don’t know if there is a formula that quantifies this.
Not 100%! Yes, in most case, higer inflation will affect equity price negatively. However, if there is a perfectly monoply firm that can pass inflation onto its price, P/E won’t chage.
assuming payout ratio = 100% -> g = 0 P/E = 1/(k+(1-lambda)*I), where k is the real required rate of return, I - inflation, lambda - percentage of inflation passed to the customers. if lambda = 1, no effect (just as ws said), if lambda < 1 -> P/E is affected.
Hi everybody ! -> maratikus Could you please give wider explanation? I haven’'t got whar lambda is… Is this formula taken from CFA materials or Scweser?
SerGrey Wrote: ------------------------------------------------------- > Hi everybody ! > > -> maratikus > > Could you please give wider explanation? I > haven’‘t got whar lambda is… > > Is this formula taken from CFA materials or > Scweser? I don’t know where it comes from, but lambda in the percentage of inlation passed on to customers. So if a steel company experiences inflation in its inputs (iron ore, electricity) of 10%, but only raises the price of steel by 5%, then lambda = 5/10 = 0.5. If however it manages to raise prices by 15%, lambda is 1.5. However, the key point isn’t lambda, just that investors (at least should be) interested in REAL returns. So in Zimbabwe, with inflation at 100,000%, investors’ real required rate of return is likely to be around 150,000%. That’s going to translate into a prettly low p/e…
I think you can look for this formula in study session 10 where the description for Franchise value is also explained… just after that there is an explanation for inflation effects on P/E ratio. Inflation negatively affects P/E ratio unless the flow through (the amount of inflation that can be passed onto the customer) is 1. Hope that helps.