At extreme ends, high inflation and deflation is very detrimental to businesses and the economy.
Japan is a great example of an economy that’s suffering from many years of deflation and low inflation. For example, the Japanese government has for some time been trying with no success to increase the inflation rate to about 2% to successfully revive the economy.
Any economy with no healthy inflation will be stagnant.
Although low prices will typically benefit consumers, a fall in overall prices over extended periods can result in a sluggish economy of stagnant wages and low corporate investments. This is exactly what happened to Nikkei 225 Index after the GDP didn’t grow because of the sluggish economy.
Inflation Is A Form Of Hidden Tax
The majority of investors are very concerned about inflation since it affects how they value a business’s future cash flow.
£100 today has more value than £100 in the future because of inflation.
In a well-discounted valuation model for cash flow, we need to discount a business Future Value (FV) to the Present Value by estimating the zero-risk interest rates or how much the inflation will be in the foreseeable future.
For the consumers, their purchasing power becomes weaker over time due to inflation. To emerge victorious against inflation, consumers must increase their earning power by working harder and produce returns that are higher than the inflation rate.
In the same way for businesses, incase the average nominal return rate on the equity is about 12% post-tax, a 7% rate of inflation gives a 5% real turn on the equity. That’s the simplest way of calculating the real returns.
So, inflation is a form of hidden tax. Low inflation gives investors high real returns and higher inflation will erode the real returns.
How should investors navigate investing considering we are living in a highly inflationary environment?
As consumers, we all want to boost our earning power more than the inflation rate. A higher earning power is much better.
The same applies to businesses; a great business will be in a position to pass on this inflationary cost to buyers. In the long run, if they can successfully increase the prices at a faster rate than the cost of services and products, inflation shouldn’t be a big concern.
Ways Businesses Can Minimize The Damage?
Increase In Turnover
Increasing the turnover means increasing revenues and sales.
The return on equity will improve incase the business passes on the increase in costs to buyers.
A business, that’s superior will be asset-light, doesn’t need to manufacture services or products, and has subscriptions depending on the recurring revenues.
Access Cheaper Leverage
The higher inflationary environment causes the interest rates to increase, which ultimately results in a depressing return on equity.
Companies that can minimize their borrowing costs by raising capital raised by shareholders through convertible bonds or stocks with reduced stock dilution will be beneficial.
Additional Leverage Boosts Return On Equity.
Nonetheless, businesses that need high debt for them to operate will most likely perform poorly during periods of higher inflation with the increased costs of borrowing.
Businesses with lower debt will be in a position to take additional leverage for increased return on equity.
Wide Operating Margins
Companies with the economics of scale, have high sales efficiency, are asset-light and low costs of services and goods will command high operational efficiency.
Great companies will have high margins.
Its obvious, low-income tax will result in increased returns.
While this is rare in business control, we can’t legally escape from taxation.
Inflation affects all of us
Even in periods of higher inflation, typically all businesses and companies will be affected.
It’s the same for taxes; every business is subject to similar tax rates, without any preferential treatment. Businesses can’t control taxes or the rate of inflation. As a result, businesses continue to face the same macroeconomic challenges.
How To Protect Your Investment Against Inflation
The best way through which you can protect yourself against inflation is by choosing to invest in assets that can keep up with higher inflation or deflation. It’s the only way of doing it. If you’re in business, it’s highly likely your business will keep up with the inflation, unless you’re in the healthcare sector. Real estate is another great asset that always keeps up with information.
What is the UK’s inflation rate and why does it matter? (2021, June 16). BBC News. https://www.bbc.com/news/business-12196322
BBC NEWS | The reporters | Evan Davis. (07, November 13). BBC. https://www.bbc.co.uk/blogs/thereporters/evandavis/2007/11/why_inflation_matters.html
Reuters. (2021, April 9). Take five: Who’s afraid of U.S. inflation? https://www.reuters.com/business/take-five/global-markets-themes-takealook-2021-04-09/