Companies must do more than keep up with price increases in order to keep shareholder value over long periods.
Inflation threat lingers over corporate profits
Whatever role low interest rates and high government spending may have played in helping economies stabilise during the global slowdown, they now have companies, investors, and policymakers on the lookout for inflation to come roaring back.
Economists are already warning of a return to the experience of the 1970s, when inflation in the developed countries of Europe and North America hovered at about 10 per cent. That level is not uncommon in Latin America and Asia, where emerging economies have seen double-digit inflation for many years. At first glance, the effects of inflation on a company's ability to create value may seem negligible. After all, as long as managers can pass increased costs on to the customer, they can keep inflation from eroding shareholder value. Most managers believe that to achieve this goal, they need only ensure that earnings grow at the rate of inflation.
But a closer examination reveals that to fend off inflation's value-destroying effects, earnings must grow much faster. That is a target companies typically do not hit, as history shows. In the mid-1970s to the 1980s, for instance, US companies managed to increase their earnings per share at a rate roughly equal to that of inflation - about 10 per cent. But to preserve shareholder value, our analysis finds, they would actually have had to increase their earnings growth by about 20 per cent. This shortfall was one of the main reasons for poor stock market returns in those years.
Inflation makes it harder to create value for several reasons, especially when its annual growth rate exceeds long-term levels of between 2 and 3 per cent, and becomes unpredictable for managers and investors. When that happens, it can push up the cost of capital in real terms and lead to losses on net asset positions that are fixed in nominal terms. But inflation's biggest threat to shareholder value lies in the inability of most companies to pass on cost increases to their customers in full without losing sales. When they fail to pass on all of their rising costs, they are unable to maintain their cash flows in real terms.
To illustrate the point, let us examine the case of a hypothetical company that generates steady sales of $1,000 (Dh3,672) a year, with earnings before interest, taxes and amortisation (Ebita) of $100 and invested capital of $1,000. If the cost of capital is 8 per cent, the company's discounted cash flow value at the start of year two equals $1,250.2. Now assume that inflation suddenly increases from zero to 15 per cent in year two and stays at that level, 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 per cent 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 per cent after 15 years. This level of performance may seem impressive or at least adequate. Yet not all is as it seems. The growth of free cash flows would be negative in the first five years and only gradually rise to the rate of inflation after 17 years.
That, combined with an increase in the cost of capital, to 24 per cent, pushes down the company's value to as little as $481.50. To fully pass on inflation to customers without any loss of sales, the company would need to raise its cash flows at the rate of inflation, not its earnings, as many practitioners surmise. But if all cash flows grow with inflation, the implication is that the company's reported financial performance increases sharply.
In year two, earnings growth would have to exceed 33 per cent; sales margins would have to increase to 11.6 per cent, from 10 per cent; and returns on invested capital (ROIC) to 13.4 per cent, from 10 per cent. After 15 years of constant inflation, margins and ROIC would end up at 17.6 per cent and 34.7 per cent, respectively. The company's ROIC must rise that far to keep up with inflation and the higher cost of capital.
The reason is that invested capital and depreciation, instead of tracking inflation precisely, are usually delayed. In year two, for example, annual capital expenditures increase by 15 per cent, but this adds only negligibly to invested capital. Annual depreciation also changes in year 36 by only a small amount. And because in each year only one 15th of the company's assets are replaced at inflated prices, it takes 15 years of constantly rising prices to reach a steady state where capital and depreciation grow at the rate of inflation. All the while, sales margins and ROIC increase each year until the company reaches the steady state in year 17.
Although this example is stylised, the conclusion applies to all companies: 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. Unfortunately, history shows that in periods of rising inflation, companies do not achieve big improvements in reported returns on capital. Those returns have been remarkably stable, at around 8 to 11 per cent, in the US, even during the 1970s and early 1980s, when inflation hit 10 per cent or more.
If companies had been successful in passing on inflation's effects, they would have had returns of about 25 to 30 per cent in those years. Instead, they barely managed to keep returns at pre-inflation levels. One reason companies are likely to destroy value is that they are unable pass on cost increases to customers or can do so only with a time lag. This problem is especially costly when inflation is high and unpredictable: a half-year delay in passing on 15 per cent inflation implies that revenues are always 7.5 per cent too low, causing margins to drop rapidly.
Another reason could be that managers facing inflation fail to sufficiently adjust their targets for the growth of earnings and sales margins. Keeping margins and returns on capital constant in times of inflation means that cash flows and value are eroding in real terms. Growth of Ebita in line with inflation is also insufficient for sustaining a company's value. This is even more true for leveraged indicators, such as earnings per share.
Whatever the exact reason may be, history shows that companies do not manage to pass on inflation fully, so their cash flows decline in real terms. There is also empirical evidence that in times of inflation, investors increase the cost of capital in real terms. Lower cash flows and a higher cost of capital are a proven recipe for lower share prices, just as we saw in the 1970s and 1980s. Marc Goedhart is a consultant in the Amsterdam office of McKinsey and Co, the management consultant, Tim Koller is a partner in the New York office and David Wessels, formerly of the New York office, is an adjunct professor of finance at the University of Pennsylvania's Wharton School.