Wednesday, June 2, 2021

Inflation is coming and so is inflation illusion.

Inflation illusion is a favorite topic of mine, read prior posts here.   It's a topic that comes back time and time again, usually whenever there is a hint of inflation.   Case in point - this article in Barrons

https://www.barrons.com/articles/inflation-driven-stock-market-selloff-51622470534?mod=article_inline

The key line: "Both higher yields and inflation itself erode the value of future cash flows, which makes stocks less valuable. "

This is basically inflation illusion - the idea that when bond yields increase, the discount rate for stocks should also increase, thus lowering the value of the cash flows generated by the stocks.


Here's why this is flawed logic:

The value of a firm's equity can be given as: Value=FCFE(1+g)/(R-g)

Where R = the nominal discount rate, FCFE is the free cash flow to equity and g = the nominal growth rate.   

When inflation increases, R will increase.  This alone will result in a reduction in the value of the stock.  However, inflation will also act upon g, the growth rate.  Across the economy we would expect, on average for g to increase by the increase in the inflation rate.   The net effect of R-g is that the impact of inflation gets cancelled out.

Ironically, the article above contains the line:

"That noise includes supply-chain constraints, which bring the cost of materials higher, incentivizing companies to raise prices."

Which basically says that the FCFE will increase - because prices are rising and therefore FCFE moves with inflation.

To be clear - I am not trying to beat up on a single, short, Barrons article.  Instead my point here is to show how common this mistake is.


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