Ask Invest-ability: How could inflation affect growth companies?

It’s all about valuations

A subscriber asks:

I have been reading your analysis of companies.

You refer to inflation as a potential problem for growth companies.

What measure of inflation do you have in mind for UK? And what measures of growth do you use to classify the growth companies?

It may be that your view of these measures may be different from mine, that may result in a greater or lesser impact of inflation on growth companies.

Phil Oakley replies:

Thanks for your email and questions.

On the measure of inflation for the UK, I’ve always preferred the retail prices index (RPI) as it includes costs that people have to pay – such as housing costs like insurance etc, but accept that there is a debate on this.

In terms of measures of growth to classify growth companies. The most important is revenue growth but this has to be backed up by profit growth eventually.

Investors face two main issues when it comes to inflation. The first is the ability of a company to pass on higher costs. Here, the most obvious clue you are looking for is the ability to increase selling prices without forcing your customers to buy less. Some growth companies do have an advantage in that if they are selling more stuff (volume) they can leverage their fixed overheads and compensate for higher costs somewhat through operating leverage. So in this respect, inflation can actually demonstrate the strength of a company’s business model.

The chief problem for growth companies that comes from inflation is the valuation of their shares. High growth tends to attract high valuations which are based on expectations of much bigger profits far into the future. Higher inflation reduces the buying power of money. The further away that money(profit) is from being received the bigger negative impact that inflation has on the value of future profits expressed in today’s money (present value).

A more simple way to look at it is that high valuations can be expressed in low yields such as earnings or free cash flow yields. For example, a 2% free cash flow yield for a company that is expected to grow strongly (10% +) may be fine if interest rates are zero and inflation is negligible. If inflation is 5-6% then this does not look as attractive as the yield is less than inflation.

We know from history such as the 1970s that high inflation can decimate the valuation of shares and bring the multiples down and push yields up. This is more of a problem for expensive shares than cheaper ones as there is more adjustment required. 

Of course, growth companies that can increase prices and keep on selling more may be able to outpace the impact of inflation depending how severe it is and the general comment that inflation is a problem for growth companies may not apply.

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