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Fending off inflation’s value-destroying effect

Whatever role low interest rates and high government
spending may have played in helping economies to stabilise during this global
recession, they now have companies, investors and policymakers keenly watching
for signs of a return to inflation.

Some economists are already warning of a return to 1970s levels, when
inflation in the developed countries of Europe and North America hovered at
around 10%. If this happens, there could be a real threat to businesses’ ability
to create value for their shareholders.

At first glance, the effects of inflation on the ability to create value
might seem negligible, since businesses are used to passing the impact on to
customers through higher prices for their products and services. Most managers
believe that to achieve this, they need only ensure earnings grow at the rate of
inflation.

But closer analysis reveals that to fend off inflation’s value-destroying
effects, earnings must grow much faster than inflation ­ a target companies
typically don’t hit even in good times. In the mid-1970s to the 1980s, US-based
companies managed to increase their earnings per share at a rate roughly equal
to that of inflation, around 10%. But to preserve shareholder value they would
have had to increase their earnings growth by around 20%. That shortfall was one
of the main reasons for poor stockmarket returns.

Inflation makes it harder to create value for several reasons, but its
biggest threat is the inability of most companies to pass on cost increases to
their customers fully, without losing sales volume. When they don’t pass on all
of their rising costs, they fail to maintain their cashflows in real terms.

For example, a hypothetical company that generates steady sales of £1,000
every year, with earnings before interest, taxes and amortisation of £100 and
invested capital of £1,000. If the cost of capital is 8%, the company’s
discounted cashflow value at the start of year two equals £1,250.

Assume that inflation suddenly increases from zero to 15% in year two and
stays at that level in perpetuity, and that costs and capital expenditures are
affected equally.

Also assume that the company can increase its earnings at the rate of
inflation and maintain its 10% sales margin by increasing prices for its
products, while keeping sales volumes and physical production capacity constant.
In the process, it will lift its returns on capital to almost 20% after 15
years.

This level of performance seems impressive, but not all is as it seems. The
growth of free cashflow would be negative in the first five years and only
gradually rise to the rate of inflation, in year 17. That, combined with an
increase in the cost of capital to 24% pushes down the company’s value to around
as little as £308. To fully pass on inflation to customers without any loss of
sales volume, the company would need to raise its cashflows at the rate of
inflation ­ not its earnings.

Keep up with inflation
If cashflow grows with inflation, though, the implication is that the company’s
reported financial performance increases sharply. In year two, earnings growth
would have to exceed 33% and sales margins would have to increase to 11.6%, from
10.0%. Returns on invested capital (ROIC) would need to increase to 13.4% from
10.0%. After 15 years of constant inflation, margins ROIC would end up at 17.6%
and 34.7% respectively. The company’s ROIC must rise that far to keep up with
inflation and the higher cost of capital, because invested capital and
depreciation, instead of tracking inflation precisely, are usually delayed.

Annual depreciation will change in year three by only a small amount. And
because in each year just 1/15th of the company’s assets are replaced at
inflated prices, it takes 15 years of rising prices to reach a steady state
where capital and deprecation grow at the rate of inflation.

What does this mean? After each acceleration in inflation, reported earnings
should be expected to outpace inflation and reported sales margins and returns
on capital to increase, even though in real terms nothing has changed. But in
periods of rising inflation, companies do not achieve big improvements in
reported returns on capital.

Instead, they tend to remain stable at around 8% to 11% in the US. If
companies had been successful in passing on inflation’s effects, they would have
enjoyed returns of up to 30% in those years ­ but they barely managed to keep
returns at pre-inflation levels.

Growth in line with inflation is not enough to sustain a company’s value.
Whatever the exact reason may be, companies do not manage to pass on inflation
fully, so their cashflows decline in real terms. It’s something FDs need to keep
an eye on in the next couple of years.

Marc Goedhart and Tim Koller are partners with McKinsey. David
Wessels is an alumnus of McKinsey New York and an adjunct professor of finance
at Wharton

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