A:

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 price-to-earnings 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.)

RELATED FAQS
  1. 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 price-to-earnings ratio (P/E ratio) is calculated as a stock's current ... Read Answer >>
  2. What is the average price-to-earnings 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 >>
  3. What is the difference between forward p/e and trailing p/e?

    Understand the difference between the trailing P/E ratio, which is the standard price-to-earnings calculation, and the forward ... Read Answer >>
  4. What is an alternative ratio to forward p/e?

    Discover the most commonly used alternative equity evaluation ratio to the forward P/E ratio, and the relative advantages ... Read Answer >>
  5. Where can I find the P/E ratios for the Dow and S&P 500?

    When it comes to valuing stocks, the price-to-earnings (P/E) ratio is one of the oldest and most frequently used metrics. ... Read Answer >>
  6. Can a stock have a negative price-to-earnings (P/E) ratio?

    Yes, a stock can have a negative price-to-earnings ratio (P/E), but it is very unlikely that you will ever see it reported. ... Read Answer >>
Related Articles
  1. Investing

    Getting On The Right Side Of The P/E Ratio Trend

    Buying at the right time is crucial, but how do we know when that is?
  2. Insights

    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 ...
  3. 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.
  4. Trading

    Coping With Inflation Risk

    Inflation is less dramatic than a crash, but it can be more devastating to your portfolio.
  5. Investing

    How To Use The P/E Ratio And PEG To Tell A Stock's Future

    While the price-to-earnings ratio is commonly used for assessing stock prices, the price/earnings-to-growth ratio offers forecasting advantages that investors need to know.
RELATED TERMS
  1. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  2. Forward Price To Earnings - Forward P/E

    A measure of the price-to-earnings ratio (P/E) using forecasted ...
  3. P/E 30 Ratio

    The price-to-earnings (P/E) ratio is the valuation ratio of a ...
  4. Inflation Trade

    A method of investing that seeks to profit from an overall increase ...
  5. Inflation Protected

    The types of investments that provide protection against inflation ...
  6. Headline Inflation

    The raw inflation figure as reported through the Consumer Price ...
Hot Definitions
  1. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment is made with the expectation of earning a return on it. This ...
  2. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
  3. Buyback

    The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies ...
  4. Tax Refund

    A tax refund is a refund on taxes paid to an individual or household when the actual tax liability is less than the amount ...
  5. Gross Domestic Product - GDP

    The monetary value of all the finished goods and services produced within a country's borders in a specific time period, ...
  6. Inflation

    The rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of ...
Trading Center