I am finding it difficult to understand this concept of Inflation flow through - can any of you please help and explain in simple words here? TIA!
Look at Inflation as a substitute for growth. Also assume that entire earnings are distributed as dividends, just to make things simple. typical company-> with growth --> E1=E0*(1+g) where growth rate applies. With Inflation: E1=E0*(1+I) where I=Inflation. When you value typical company: P0=E1/(r-g) --> DDM full earnings distributed as Earnings. So applying to Inflation situation, g=I P0=E1/(r-I) Also remember -> r = Nominal rate = Rho (Real Rate) + I. So with Inflation, and full flow thro -> P0=E1/rho. When full flow thro’ is not available, and only a portion can be passed thro: Lambda=Portion of pass thro. E1=E0*(1+lambda*I) g=Lambda*I Substituting P0=E0*(1+Lambda*I)/(r-lambda*I) r=rho+I so P0=E1/(rho+lambda-lambda*I) = E1/(rho + (1-I)*Lambda)
@ckp123: simple words? hahaha Just think about it this way, if you have high inflation then as a manufacturer you will have to pay more money for your production inputs. If you are able to charge an accordingly higher price for your product (you are passing along the inflation, i.e. you have a high "inflation pass-through), then your realized price (inflation adjusted) remains the same: costlier production input, but also higher sales price, right? So for a firm that can pass on all of the inflation to the buyers of its product, nothing changes. If, however, you have no or only little pricing power, you may not be able to do this. So you are paying more for the inputs, but are only charging a moderately higher sales price - i.e. you lose
the last formula should be: P0=E1/(rho+I-I*lambda) = E1/(rho + (1-Lambda)*I) but it is typo… anyway I have a question. What if growth is not 0 (dividend payout ratio < 100 %)?
The E1 term in the equation would become E1*(payout ratio) , if we assume that payout ratio is going to be the same in the next period.
@Kingstongal - thanks so much @ cpk - lol it’ll take me 10 days to understand whatever you mentioned above.