The Obama administration and the US Congress are laying the foundations for high inflation when the economy eventually recovers from the recession.

US equity investors should be ready for the effect that a rapidly devaluating currency may have on earnings-per-shares and price-earnings ratios.

How inflation increases corporate taxes

Companies with fixed assets are usually allowed to deduct the depreciation of these assets based on historical cost.

For example, if a company buys a machine for $10 million with an expected life of 10 years and no residual value, it may be able to deduct $1 million a year from income, thereby effectively reducing its tax burden.

When inflation is three percent a year, the tax benefit from depreciation will be reduced by about 15% over a ten year period, compared to the real value of the deduction that would have accrued in a non-inflationary environment.

However, if inflation were to run 25% over a ten year period — as has occurred in developing economies that can’t get government spending under control, the tax benefit from depreciation will be reduced by 76%.

For companies with substantial fixed assets and the need to replace depreciating equipment, high inflation, combined with declining deductions for deprecation, in real terms, will effectively increase their corporate tax burden, reducing cash reserves, and threatening continued operations.

Since, under inflation, government spending is out of control, the authorities are not amenable to lowering taxes, forcing corporations to increase prices faster than current inflation to stay in business.

This leads to even higher inflation.

Distortion of asset values

Some balance sheet assets, such as land, are not subject to depreciation.

If a company spends $10 million dollars to buy a piece of land on which to build a factory, that land will still be on the books for $10 million ten years later.

With inflation of 25% a year, all things being equal, the land might actually be worth $40 million at current prices at the end of the decade. As time goes on, the balance sheet will increasingly be distorted by inflation.

After a long period of high inflation, the same accountants who are now ardently defending “mark-to-market” rules as being in the investors’ interests, will be defending the age-old practice of keeping non-depreciable assets on the books at historic costs, although these numbers are now entirely meaningless.

Distortion of earnings

The corollary of increased taxes due to the effect of inflation on depreciation reserves is the reduction in the real value of reported earnings, due to understated depreciation.

Inflation also creates other problems for the interpretation of earnings, such as the effect on the cost of goods sold and inventory valuation.

Companies that are wise enough to keep track of the distortion of earnings due to inflation may be able to pass these hidden costs on to clients, but the investor will never be sure.

The accounting system is not designed to report results in real terms.

Earnings per share, therefore, in an inflationary environment, become increasingly difficult to interpret. A company that is not raising prices fast enough, may be depleting its capital base, and the investor will never know until it is too late.

What is an appropriate PE ratio when inflation is 25%?

This is a trick question, because there is no correct answer.

The fundamental value of equities, based on John Burr Williams’ formula [D/(I-G)], depends on dividends paid, the rate of growth of dividends, and the investor’s expected rate of return.

With inflation of 25%, short-term interest rates might be 27%. If dividends were expected to grow along with inflation, this would suggest that the PE ratio might not be that different from a non-inflation environment in which dividends were growing 2% faster than short-term interest rates.

However, with high inflation, there might be considerable more uncertainty as to the value of the earnings stream and the sustainability of the dividend rate.

And then, of course, there will be some companies that do not pay dividends, causing the value of their stocks to be indeterminate.

What does history teach us about PE ratios and inflation?

If we look at the history of stock prices in developing markets during periods of high inflation, we find no pattern to suggest any particular level of PE ratios as being appropriate.

In Brazil, during the 1960s, PE ratios of good companies ranged from 4 to 10 times earnings. In the early 1970s, these same companies were trading from 15 to 30 times earnings, with about the same rate of inflation.

In Indonesia, during the early 1990s, with inflation about 6 to 8%, PE ratios of 20 to 30 times earnings were observed.

In the extreme hyper-inflation of Brazil in the late 1980s, when the government allowed monetary correction of asset values and depreciation, stocks no longer traded on the basis of PE ratios, but rather in multiples of book value.

In short, inflation causes great uncertainty about the real value of equities and stock prices tend to be volatile.

Not unlike the situation in the US stock market today.

Do you think that inflation of 25% is unrealistic?

How realistic is the current budgetary behavior of the US government?

This entry was posted on Wednesday, April 8th, 2009 at 1:17 pm and is filed under Equities, Individual Investors, Government Officials, Equity Risk. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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