If one believes that the value of a company is the sum of its future discounted cash flows, then it is quite essential to be able to determine the discount rate correctly. At the moment, market interest rates are still close to zero, while inflation hovers around five percent.
The question is: What effect does inflation have on the discount rate? At least I would want the discount rate to be higher than inflation, and of course, the risk associated with the investment target must also be compensated.
The safest option, nominally measured, is to keep money in a bank account, but there the value of money is currently disappearing at an annual rate of 5%. To reach real net-zero, an investment needs to yield at least 5% return per year.
The discount rate answers the question of how much return you require to be willing to invest in an instrument considered risky. Peer-to-peer lending is risky and therefore high-interest because there is an elevated probability that the borrower will not repay their debts. A stock is risky because there are uncertainties associated with companies’ ability to generate profits. Markets can be very positive about companies’ ability to grow and generate profits, in which case P/E ratios soar into the hundreds, and the realistic expected return on the stock is very weak. Similarly, markets can be pessimistic about a struggling company, but it may be that the difficulties prove to be temporary.
Inflation is a reality that does not depend on your asset allocation. Therefore, it should not affect investment decisions. Example: you invest in a company’s shares. A year later, the stock is at 0.9x the value you paid. Inflation is 5%. With your assets, you would get 0.9 / 1.05 - 1 = -14.3% fewer goods than a year ago. If you had kept the asset in cash, you would get 1 / 1.05 - 1 = -4.8% less. It is entirely possible that all options are negative, some just more so than others. If you get sick, the option is to lose money by buying medicine, or not to buy medicine and suffer from the illness.
So, inflation does not change the discount rate. The options are still a 0% return bank account and a 5% return stock, regardless of the inflation rate. Tightening central bank monetary policy would change these relationships. If a bank account were to yield 1%, then a stock should yield 6%, which would lower the stock price. Some companies are better able to pass on increased costs to prices than others. The market has a characteristic that if something seems obvious, it often gets priced in. Falling stock prices anticipate a future interest rate hike.
Are you claiming that inflation does not affect the investment decisions of people, companies, or markets?
Your claim might be theoretically true and hold for a perfectly diversified portfolio in the long run, but somehow, I can’t believe that inflation wouldn’t have an impact on markets in practice, even if interest rates don’t rise or aren’t expected to rise, especially in the short term.
If inflation were, say, 200%, I think it’s clear that in such a situation, the allocation to cash should at least be kept close to zero and preferably negative through fixed-rate debt. In a world of high inflation, the present value of cash flows far in the future is also small if inflation is high.
A world with high inflation favors assets that generate cash flow today rather than the day after tomorrow. In such a world, the discount rate is higher. Of course, if one assumes future cash flow will grow with inflation (= pricing power), then the discount rate does not need to be raised.
Raw material inflation can make some business operations unprofitable. Agriculture, for example, is currently struggling due to increased prices and poor availability of fertilizers. On the other hand, the situation can benefit companies that produce precisely those commodities that are scarce.
In a hyperinflationary environment, cash becomes worthless. Does cash flow calculation even matter then? The currency then becomes a “toxic asset” that no one wants. Trade is conducted through bartering real assets or using another foreign currency. A Turkish merchant would rather accept your euros than liras.
The share price can be thought of, in simplified terms, as being composed of earnings and a valuation multiple, i.e., the P/E ratio. The inverse of this is the earnings yield. If earnings remained the same, E/P would correspond to investors’ required rate of return. Cost inflation will likely weaken companies’ earnings, and thus share prices will face downward pressure. If valuation multiples remained the same, a 10% earnings decline would result in a 10% drop in the share price. A smaller decline would mean an increase in valuation multiples. This might seem paradoxical at first glance that weakening earnings would be valued higher, but this often happens with cyclical companies.