Question on the relationship between Pass-through rate and Justified P/E

CFA Level II Equities
#1

Hi guys, I am trying to understand the relationship between passthrough rates and justified PE on a conceptual basis. Any thoughts/input would be greatly appreciated. (Level 2, CFAI curriculum, Equity, pg. 405)

Conceptually: Why does a higher pass-through rate (holding inflation rates constant) create a higher justified P/E? (pass-through rates in terms of passing inflation cost to customers, not coupon rates)

  • If a higher pass-through rate allows companies to pass more inflation costs to revenues/customers, shouldn’t that increase earnings on a nominal basis? So wouldn’t P/E be lower?
  • My guess was that a higher pass-through rate increase the stock price due to lower inflation costs passed on to the company (when compared to companies with a lower pass-through rate). Therefore it doesn’t directly affect earnings, it affects the P/E ratio inversely.

What is the pass-through rate’s effect on Price and what is its effect Earnings? (When analyzing just one company)

FYI if it makes explaining my question any easier- I understand that if two companies have the same pass-through rate, increases in inflation will lead to lower justified P/E because inflation is the “growth rate” to earnings.

#2

Well, it should normally leave P/E the same if the only factor in this case is inflation. But since not all companies can pass through inflation, then P/E would be relatively ‘higher’ in this case. A weaker ability to pass on inflation to customers is a risk for the company, and will demand a higher discount rate, thus the effects on PE, while controlling for payout and growth.

#3

Great explanation, thank you.