Inflation affects equity prices in several ways. Most importantly, investors are willing to pay less for a certain level of earnings when inflation is high, and more for a certain level of earnings when inflation is low (and expected to remain so).
Let's review the two concepts involved: the pricetoearnings ratio (P/E) and inflation. The P/E ratio is a valuation measure showing how much investors are willing to pay for a company's earnings. For example, if the price of a stock is $50 and earnings per share is $2, then the P/E ratio is $25 ($50/$2). This shows that investors are willing to pay 25 times the company's earnings. Inflation is a measure of the rate of price increases in the economy.
P/E is affected by inflation in the following ways:
1. Stable and moderate inflation means a higher probability of continued economic expansion. Modest inflation usually means that the central bank won't be raising interest rates to slow economic growth. When inflation and interest rates are low, there is a greater opportunity for higher real earnings growth, increasing the amount people will pay for a company's earnings. The more people are willing to pay, the higher the P/E.
2. When inflation levels are stable and moderate, investors have lower expectations of high market returns. Conversely, expectations rise when inflation is high. When inflation rises, so do prices in the economy, leading investors to require a higher rate of return to maintain their purchasing power.
If investors demand a higher rate of return, the P/E ratio has to fall. Historically, the lower the P/E, the higher the return. When you pay a lower P/E, you're paying less for more earnings and, as earnings grow, the return you achieve is higher. In periods of low inflation, the return demanded by investors is lower and the P/E higher. The higher the P/E, the higher the price for earnings, which lowers your expectations of healthy returns.
3. During times of low inflation, the quality of earnings is considered to be high. This refers to the amount of earnings that can be attributed to actual growth in the company and not to outside factors like inflation. For example, say inflation is 10% per year (which is high), and a company purchases a widget for $100. In one year, the company will be able to sell that same widget for at least $110 because of inflation. Because its cost for the widget remains $100, it appears to have increased profit margins, when really the growth is all inflation's doing. In general, investors are more willing to pay a premium, or a higher multiple, for actual growth compared to artificial growth caused by inflation.
History has shown that investors realize this phenomenon and take inflation into account when valuing stocks. When inflation is high, P/E ratios are low; when inflation is low, P/E ratios are high.
(For further reading, see our tutorials Understanding The P/E Ratio and All About Inflation.)

What does the forward p/e indicate about a company?
Explore the forward price to earnings ratio and learn its significance and how it compares to the traditional price to earnings ... Read Answer >> 
Stocks with high P/E ratios can be overpriced. Is a stock with a lower P/E always ...
The short answer? No. The long answer? It depends.The pricetoearnings ratio (P/E ratio) is calculated as a stock's current ... Read Answer >> 
How do I calculate the P/E ratio of a company?
Find out how to calculate this common valuation ratio and what the results can tell you about a company's performance. Read Answer >> 
How can the pricetoearnings (P/E) ratio mislead investors?
A low P/E ratio doesn't automatically mean a stock is undervalued, just like a high P/E ratio doesn't necessarily mean it ... Read Answer >> 
What is the average pricetoearnings ratio in the banking sector?
Explore the price/earnings ratio in regard to the banking industry and learn what the average P/E ratio is for most banking ... Read Answer >> 
What's the difference between absolute P/E ratio and relative P/E ratio?
The simple answer to this question is that absolute P/E, which is the most quoted of the two ratios, is the price of a stock ... Read Answer >>

Managing Wealth
Inflation's Impact On Stock Returns
When stocks are divided into growth and value categories, the evidence is clear that value stocks perform better in periods of high inflation, and growth stocks perform better during periods ... 
Investing
Beware False Signals From The P/E Ratio
The P/E ratio is a simple tool for evaluating a company, but no one ratio can tell the whole story. 
Investing
Is Stock With a Lower P/E Always A Better Choice?
Is a stock with a lower P/E always a better investment than a stock with a higher one? The short answer is no, but it depends on a few things. 
Investing
Comparing the P/E, EPS And Earnings Yield
Here are three ratios that help investors value stock returns. 
Investing
Differences Between Forward P/E And Trailing P/E
The most common types of price to earnings ratios are forward P/E and trailing P/E. Find out how they differ and the advantages and drawbacks of each. 
Markets
How Inflation Affects Your Cash Savings
Prices tend to rise over time and this inflation can cut into the value of your savings. Here are some ways you can manage the situation. 
Markets
Should You Worry About the U.S Inflation rate?
Understand how inflation is measured, how U.S. inflation compares to other countries, and if investors should be concerned with rising inflation. 
Markets
Macroeconomics: Inflation
By Stephen Simpson Inflation is a key concept in macroeconomics, and a major concern for government policymakers, companies, workers and investors. Inflation refers to a broad increase in prices ... 
Markets
Understanding Core Inflation
Core inflation is a measure of inflation that excludes certain items that have volatile price movements. 
Markets
How Do I Calculate the PriceEarnings Ratio?
If Apple is trading at $108.73 per share, and its trailing twelve months' EPS is $6.45, calculate the P/E ratio as...

PriceEarnings Ratio  P/E Ratio
The PricetoEarnings Ratio or P/E ratio is a ratio for valuing ... 
Forward Price To Earnings  Forward P/E
A measure of the pricetoearnings ratio (P/E) using forecasted ... 
P/E 30 Ratio
The pricetoearnings (P/E) ratio is the valuation ratio of a ... 
Inflation Trade
A method of investing that seeks to profit from an overall increase ... 
Inflation Protected
The types of investments that provide protection against inflation ... 
Trailing PriceToEarnings  Trailing P/E
The sum of a company's pricetoearnings, calculated by taking ...