I am having troubles conceptually… The Facts: -the higher the inflation flow-through, the higher the price of the company, a company that cannot pass its inflation through its earnings is penalized. -higher inflation, the more negative the influend on the stock price if full flow through cannot be acheived. the book seems to state these like they are rules to live by. but i beleive that it is a case by case basis. 3 things: when they say this, are they saying the prospective price rises from the prospective inflation if full flowthrough occurs? the way i see it is if you have full flow through, you pass the inflation costs on to your consumers, which allows your Earnings not to drop… i.e. earnings is higher with a full flow thorugh -> P/E is then lower??? (not according to the book) isn’t a lower P/E more desirable?? this says “a company that cannot pass its inflation through its earnings is penalized.” it also says if you pass through the inflation P goes up… i.e. P/E goes up (not desirable…?) doesn’t this also depend on the industry the company is in?? an exporting industry would gain from a depreciation in currency and an importing comapny the opposite? i can memorize this but i still don’t get it. thanks s
If I remember correctly, the impact of inflation on P/E can be summarized as follows: 1 / 1+I(1-lamda) where “I” is inflation and lamda is the flow-through rate. So let’s try out two scenarios: 1) the company can pass through 100% of the cost of inflation to its customers (i.e. lamda=1). Notice that in this case, no matter how high inflation is, the P/E ratio is unaffected as the quotient is still 1/1 = 100%. 2) okay now the company can only pass through 50% of the cost of inflation (i.e. lamda=0.50). So now, the higher inflation, the more the company’s P/E is punished, all else equal. The lower lamda is, the greater the impact of I. As for the rest of your question, I think you’re convoluting things. Who says a lower P/E is better? Maybe if you’re a value investor looking for a good deal. But what if you’re a corporate executive? I guarantee you don’t want to promise your shareholders that you’ll strive for the minimum possible P/E for their equity… the reward for that achievement is building security escorting you briskly to the front door. Also, differentiating among industries has only one impact on this inflation analysis: it dictates the level of lamda. The cost of inflation must be shouldered by someone and bargaining power between suppliers and consumers will dictate how this plays out. Check out Porter’s Five Forces, for example. Otherwise, industry analysis plays no role here. Let’s leave currency appreciation/depreciation out of the picture too, though your observations are correct. Anyway, hopefully this helps, let us know if you need additional clarification. edit: apparently the lamda symbol doesn’t fly in AF.
this helps thanks! -S