The role of inflation in valuation

Our simple approach to valuation was described in a recent blog. However, though simple, we find it to be effective in focusing on what really matters: long term corporate profitability - rather than terminal values, theoritical discount rates or the volatility of stock prices. We would like to show the power of this model by focusing on how high inflation can affect the pricing of the stock market. Many readers are aware that during the 70s inflation rates increased and the stock market reached a valuation close to x7 earnings, a large displacement from its historical average of x16 earnings. When the value of money is perceived to decrease over time, it is rational that investors want to pay less for future cash flows, hence the multiple of the market contracts. However, focusing on those companies that have more manageable costs (consider their cost structure, its operational efficiency to competitors and the margin of the business) and pricing power, inflation over the long term will cause little permenant damage. If anything, it can increase their market share as competitors have a more difficult time, allowing the strong to become stronger. Focusing on these companies means we do not need to alter our x15 multiple on free cash flow generated. We do not adjust our multiple on macro fears: because these class of companies have suffered a number of macro issues over their many decades of existence. Their flexible management team often handle the event better than competitors, and they have the resources, balance sheet and cash flow to overcome it. Hence when we see x7 multiples as market continue to go down, we have a lens to generate the strength to buy. Of course macro environments can change our margin of safety: rather than 35% in a high inflationary environment it will be 45%: but if our approach suggests a buy, we must be ready to fight our stomachs, the biggest problem of an investor.