Have You Considered Inflation ?

Knowing how to work with the numbers in a company’s financial statements is an essential skill for stock investors. Sound knowledge of company’s balance sheet, income statement and cash flow statement helps make a smart investment choice. That said, have you considered inflation while researching a company’s financial statements ? Most probably not. Infact inflation can fool even the most sophisticated investors. Let us find out why inflation should be accounted for, when analyzing financial statements.

What Is Inflation?
Inflation is the rate at which the general level of prices for goods and services is rising and causing a fall in purchasing power. As inflation rises, every dollar you own pays for a smaller amount of a good or service. If, for example, the inflation rate is 2% annually, a $1 pack of gum would theoretically cost $1.02 in a year. Your one dollar would no longer pay for the whole pack of gum. (Source: Investopedia)

Example
Let us take an example of a company called FoolsAreUs that sells some goods. Shares of FoolsAreUs trades at $10 and they payout high dividend to their investors. Also, the company purchases all of its inventory at the beginning of the year. With these assumptions, lets look at the income statement of FoolsAreUs, with no-inflation and then with inflation in the picture.

Income Statement Without Inflation
Revenue from Operations = $22 million
Cost of Goods Sold = $20 million
Other Expenses = $1 million
This brings the Net Income = $1 million (21m – 20m)

Now as mentioned earlier, FoolsAreUs pay out dividend. Dividends Paid = $1 million

What does that leave for FoolsAreUs in terms of earnings ?
Earnings = $1 million – $1 million = $0

Income Statement With 5% Inflation
Revenue from Operations = $23.1 million ($22 m x 5% inflation = $23.1 m)
Cost of Goods Sold = $20 million (since the inventory was bought at the start of the year)
Other Expenses = $1.05 million ($1 m x 5% inflation = $1.05 m)

This brings the Net Income = $2.05 million (23.1m – 21.05m)

Dividends Paid = $1.05 million (to maintain same ‘real value’ as last years)

What does that leave for FoolsAreUs in terms of earnings ?
Earnings = $2.05 million – $1.05 million = $1 million. Wow. Some magic huh…FoolsAreUs now has an extra $1 million on their income statement, This would lead us to believe that they did quite well; however, this extra $1 million in retained earnings is not free cash. FoolsAreUs must replace inventory, and inflation has increased the price to replace these goods.

Cost of Goods Sold next year will be = $21 million ($20 m x 5% inflation = $21 m)

In other words that extra $1 million for retained earnings wasn’t really profit. It reflects the difference in prices from the time the company purchased goods to the time the company sold the goods.

What happens to P/E ratio ?
Lets look at P/E ratio for FoolsAreUs with and without inflation. Assume the FoolAreUs has 1 million shares outstanding, which was used to calculate EPS.

Without Inflation
Earnings Per Share = Net Income ($1 m) / Shares outstanding (1 m) = 1.0
Price of Stock = $10
P/E ratio = Price of Stock / EPS = 10/1 = 10

With Inflation
Earnings Per Share = Net Income ($2.05 m) / Shares outstanding (1 m) = 2.5
P/E ratio = Price of Stock / EPS = 10/2.05 = 4.9

Inflation has a dramatic impact on the P/E Ratio. The ratio drops from 10 before inflation to 4.9 after calculating in the effects of inflation. As you can see, the financial statements of FoolsAreUs are overstated. Many investors get tricked here by interpreting this lower P/E ratio as a bargain.

Note: There are many issues that were not taken into account and some unlikely assumptions were made. However the important point to see here is how factoring in inflation makes a difference to calculating the expenses and revenues in financial statements.

Conclusion: Plenty of companies will show dramatic gains in their earnings during periods of high inflation. You should, therefore, interpret historical P/E’s and earnings with care. Additionally investors should always be wary of P/E ratio changes during periods of high inflation.