Over the past 12 months, inflation has approached 10 percent in the United States and exceeded double digits in the European Union and the United Kingdom. Central banks—including the US Federal Reserve, which has raised rates at the fastest pace since the 1980s—are responding forcefully, trying to tamp inflation down. There is no clear consensus on how long this period of high inflation will last.
Persistently high inflation presents challenges to value creation that haven’t been seen since the bear markets of the 1970s. Yet the reasons why inflation affects value are often misunderstood. While merely understanding the underlying dynamics does not solve them, achieving greater clarity about the effects of persistently high inflation does make it easier for managers to achieve practicable solutions and to better set their expectations along the way.
Inflation does not significantly affect the cost of capital
Books have been written about value creation. We can distill our definition into one sentence: “Companies that grow and earn a return on capital that exceeds their cost of capital create value.”1 It turns out that inflation does not affect the cost of equity capital very much. In fact, the cost of equity is surprisingly stable in real terms; by observing more than 60 years of US stock market data, we can estimate the forward-looking cost of equity for the stock market as a whole from market P/E ratios, long-term economic growth, and return on capital. Throughout the oil crises of the 1970s, the double-digit inflation of the 1980s, the internet boom and bust, the credit crisis of 2008–09, and the COVID-19 pandemic, the cost of equity has remained at about 7 percent in real terms.2
Of course, the nominal cost of equity capital moves in line with inflation, because it equals the real-term cost of equity plus expected long-term inflation. We found no evidence, however, that investors actually include an additional risk premium in real terms to the cost of capital during times of higher inflation.
Inflation does erode corporate cash flows in real terms
Since the cost of companies’ equity capital is stable in real terms, the challenge shifts next to understanding the effects of inflation on companies’ cash flows. Most companies are unable to effectively pass on to their customers the higher costs they incur. That pressure—expenses increase, but prices to customers can’t increase as much—erodes free cash flow in real terms. Yet the consequences for value creation are not immediately evident from common financial performance indicators, such as operating margin and return on capital. The problem is that accounting doesn’t handle inflation very well: depreciation and amortization tables were built for low-inflation times.
Consider the following example: the (illustrative) financials of a company that started out in year one and two with stable sales, at a constant operating margin (EBITA/sales) of 10 percent, and a constant ROIC of 10 percent. As a result, its free cash flow (FCF) is $100 per year. Projecting unchanged cash flows into perpetuity and using a cost of capital of 10 percent represents a company value of $1,000. However, to remain stable in real terms, the company’s free cash flows must keep pace with inflation (Exhibit 1).
Financial professionals will spot the challenge: net property, plant, and equipment (NPPE) and depreciation are based on historical purchase prices and, during high-inflation times, increase at much lower rates than they do in periods of lower inflation.3 If a company can’t fully pass on these expenses, free cash will suffer. Merely treading water on operating margins means that a company drifts backward; to keep up, it needs to (in this example) grow margins and returns on capital at 11.1 percent and 12.3 percent, respectively. That impressive feat merely ensures that free cash flow grows at 10 percent and stays constant in real terms.
As long as high inflation persists, margins and return on capital need to keep increasing. To illustrate, consider the (unlikely) case in which inflation persists at 10 percent for 15 years. The new equilibrium level for ROIC would be 26.2 percent—more than 16 percentage points above its real-term, pre-inflation level of 10 percent. Unless we can project the company’s nominal cash flows to grow at the 15 percent inflation in perpetuity (and then discount these cash flows at the nominal cost of capital of 26.5 percent),4 the company’s value can’t exceed its current $1,000 level.
In practice, the precise level of improvement will depend upon the rate of inflation, the asset lifetime, and the real (not nominal) return on capital in a company. Nevertheless, from this simple illustration, we can better appreciate the challenges that companies face under persistent inflation. Growing operating profits, net income, and earnings per share at the pace of inflation are apt to destroy value in a high-inflation environment.
Yet history shows that when inflation picks up, companies typically find it hard to even stay in place. Sales—even on a nominal basis—may decline, pressures on margins increase, and returns on capital fall. We found that almost all industrial sectors in the United States suffered declines in returns, margins, and nominal revenues during rising inflation between 1970 and 1990 (Exhibit 2). Among the few exceptions were companies in the energy sector, which benefited from higher prices in oil and gas, and in consumer staples, where strong brands enabled companies to pass on a larger amount of their costs to consumers. But even these sectors suffered declines in sales. For the average US company, each percentage-point increase in inflation caused a 0.15 percentage-point decline in return on capital and a 0.60 percentage-point decline in growth.
Remarkably, inflation sensitivity has been quite similar from 1990 to 2020, when the United States experienced historically low inflation. While declines of 0.15 and 0.60 percentage points may not sound like much, they may actually pose a major hindrance: just to keep cash flows and value stable in real terms, returns on capital, margins, and, of course, nominal revenues should all be moving up.
Not surprisingly, high levels of inflation in the 1970s and 1980s generated significant downward pressure on stock market valuations, with P/E ratios in the US stock market falling to levels between 5–10, well below long-term average P/E ratio levels of 15–17. Apparently, investors expected (correctly) that high levels of inflation would last for several years. Likely, investors also expected that companies could not successfully pass on the costs of inflation and increase returns, margins would erode, and growth rates would stall. Those outcomes all came true, and resulted in the erosion of cash flows in real terms.
Temporary inflation is not likely to materially affect stock market valuations. But persistent inflation will. The main challenge is not some runaway increase in the cost of capital beyond the control of managers; it is the potential decrease of cash flows, in real terms, as inflation rises. With that insight in mind, managers should not rely exclusively on reported operating margins and returns on capital; likely, these metrics are distorted by inflation. Even if profits increase in nominal terms, they may be falling on a real basis. Financial ratios should be inflation adjusted, and managers should closely monitor inflation-robust metrics, such as cash margins of profitability and operating metrics for capital efficiency (for example, inflation-adjusted revenues over capacity measures).
Clarity is a force multiplier. When managers understand what does—and doesn’t—threaten value creation, they can more effectively allocate company time and resources and be much more precise in their external communications. While a positive outcome isn’t assured, at least the unique difficulties become more clear, and the inclinations for merely treading water can be replaced with the urgency the circumstances require.
While high inflation is hard enough for businesses to manage, persistently high inflation is harder still. The challenges are all the more difficult because they are not immediately apparent. When inflation rates stay high, maintaining even previously strong operating margins won’t sustain long-term value creation.