Inflating Equity: Inflation’s Impact on Financial Statements and ROE

By Gaurang Trivedi, CFA Posted In: Economics, Equity Investments, Financial Statement Analysis, Portfolio Management

You turn on the financial news channel one morning to find the S&P 500 has soared past the 2800 mark. Stock reports indicate ongoing bullishness and you realize you have the opportunity to make more money if you go overweight in equities. Then this thought process abruptly stops.

You begin to question whether the market will rise higher or if it’s losing momentum. Inflation concerns crop up in daily stock analysis as well as the leading inflation gauges — the Producer Price Index (PPI), the Consumer Price Index (CPI), jobless claims reports, the unemployment rate, etc. You are afraid that you will invest at the top of the market and overpay for the equities in question, which would be tantamount to lower expected returns.

This is where an understanding of financial statement analysis helps. Ultimately, it is the return a firm earns on its equity that drives the share price, and inflation suppresses equity returns.

Investors who don’t understand accounting and finance are like hunters with blurred vision: They are playing a fast-moving game they will ultimately lose.

Financial statements prepared for reporting purposes combine accrual accounting, management estimates, and managerial judgment and offer critical insights. But when applied to financial analysis, they have two recurring problems:

Accountants rely on the historical cost assumption, and accounting book values seldom equal market values.Accountants don’t recognize unrealized gains and losses or imputed costs, so accounting income differs from economic income.

Hence, financial statements are at best an approximation of economic reality.

Inflation, simply put, is a rise in the general price level of an economy. On the macro economic front, inflation reduces the supply and increases the demand of loanable funds, causing interest rates to rise. The interest rates thus reflect future inflation, and the stock market tends to move inversely with interest rates.

From a micro economic standpoint, inflation distorts a company’s income statement in three distinct ways.

First, historical cost depreciation understates the true decline in the value of assets and thereby overstates reported earnings and income taxes due. Second, the cost-flow method adopted for inventory valuation affects the reported net income in different ways. First in, first out (FIFO) valuation during periods of high inflation overstates reported earnings and taxes. On the flip side, last in, first out (LIFO) valuation, while matching current costs to revenues, understates the inventory and thereby overstates the return on assets (ROA). LIFO accounting thus induces balance sheet distortions when it values inventories at original cost. This results in an upward bias in the return on equity (ROE), which is defined as the net income available to common shareholders/average common shareholders’ equity, because it undervalues the investment base on which the return is earned. Despite this shortcoming, LIFO is preferable to FIFO in computing economic earnings.

The third distortion is reflected in the impact of reported interest expense on company profits. Because of inflation, the historical interest expense is overstated, as the value of debt decreases due to inflation, which results in reported earnings being understated and consequently a decrease in taxes owed.

ROE measures the efficiency with which the firm employs owners’ capital. Management has three levers for controlling the ROE:

Earnings per dollar of sales or profit margin.Sales per dollar of asset employed or asset turnover.Amount of debt used to finance the assets or financial leverage.

The net profit margin ratio, or net income/sales, reflects the company’s pricing strategy and its ability to control operating costs. Companies with high profit margins tend to have low asset turnovers and vice versa. The asset turnover ratio, or sales/assets, measures capital intensity, with a low asset turnover indicating a capital-intensive business and a high asset turnover the opposite. The nature of a company’s products and its competitive strategy help determine the firm’s asset turnover. ROA helps measure how efficiently a company allocates and manages resources.

Companies with a high proportion of fixed costs are more vulnerable to declining sales. Businesses with predictable and stable operating cash flows can safely take on more financial leverage than those facing more market uncertainty. Firms with low ROA generally employ more debt financing, and vice-versa.

As a measure of financial performance, ROE has three deficiencies:

Temporal analysis: ROE necessarily includes earnings for only one year, so it frequently fails to capture the full impact of longer-term decisions.Valuation divergence: A high ROE may not be synonymous with a high return on investment to shareholders because of possible divergence between the market value of equity and its book value,Risk ignorance: ROE scrutinizes only the return and ignores the risk associated with generating those returns.

A critical first step in company analysis is to determine the industry distribution of the firm’s revenues and at what stage each major industry segment is positioned in the industry’s life cycle. Second, investors must understand that earnings per share (EPS) = ROE x book value per share. So the growth of net income per share can result from an increase in the return on stockholders’ equity, an increase in stockholders’ equity per share, or both.

After piecing all the financial information together, investors must determine what kind of future growth rate the company can sustain over the next five to 10 years. A firm’s sustainable growth rate is the maximum pace at which its sales can increase without depleting its financial resources. It is nothing more than the company’s growth rate in equity. Put another way, growth rate = retention rate x ROE.

Mature and declining companies often invest considerable resources in new products or firms that are still in their growth phase. If managers, creditors, and investors base their decisions on historical cost financial statements, inflation reduces a company’s sustainable growth rate. If they adjust for inflation, it has comparatively little effect on the sustainable growth rate.

Historical cost accounting tends to understate long-term assets and overstate long-term liabilities on the balance sheet. Also, inflation increases the amount of external financing required and the company’s debt-to-equity ratio when measured on its historical cost financial statements. Inflation distorts the reported earnings figure and overstates true economic earnings. Hence the price-to-earnings (P/E) ratio drops.

A company’s P/E ratio depends on two factors:

Future earnings prospects.The risk associated with those earnings prospects.

The P/E ratio therefore reflects the market’s optimism about a company’s growth prospects. When growth opportunities dominate the estimate of total value, the firm will have a higher P/E ratio. In general, the P/E ratio gives little information about the company’s current financial performance.

When the expected rate of inflation is low, the earnings yield, or EPS/price, on stocks should exceed the yields to maturity on bonds. When the expected rate of inflation is high, the reverse should be true. A bright future, a high stock price, and low earnings yield go together.

Investors should focus on the ROE as it is impacted by EPS, which in turn determines the sustainable growth rate and finds its way into the price of the equity security through the P/E ratio.

As Abraham Brilloff observed, “Financial statements are like fine perfume: to be sniffed but not swallowed.”

And that’s worth keeping in mind the next time you consider overweighting equities.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.