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.)

  1. Who decides to print money in Canada?

    In Canada, new money comes from two places: the Bank of Canada (BOC) and chartered banks such as the Toronto Dominion Bank ... Read Full Answer >>
  2. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  3. Is Argentina a developed country?

    Argentina is not a developed country. It has one of the strongest economies in South America or Central America and ranks ... Read Full Answer >>
  4. Are Social Security benefits adjusted for inflation?

    Social Security benefits are adjusted for inflation. This adjustment is known as the cost of living adjustment (COLA). For ... Read Full Answer >>
  5. When has the United States run its largest trade deficits?

    In macroeconomics, balance of trade is one of the leading economic metrics that determines the trading relationship of a ... Read Full Answer >>
  6. How can EV/EBITDA be used in conjunction with the P/E ratio?

    Because they provide different perspectives of analysis, the EV/EBITDA multiple and the P/E ratio can be used together to ... Read Full Answer >>
Related Articles
  1. Investing

    Have Commodities Bottomed?

    Commodity prices have been heading lower for more than four years, being the worst performing asset class of 2015 with more losses in cyclical commodities.
  2. Fundamental Analysis

    Emerging Markets: Analyzing Colombia's GDP

    With a backdrop of armed rebels and drug cartels, the journey for the Colombian economy has been anything but easy.
  3. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  4. Investing

    A Look at 6 Leading Female Value Investors

    In an industry still largely predominated by men, we look at 6 leading female value investors working today.
  5. Fundamental Analysis

    Value Investing Strategies in a Volatile Market

    Volatile markets are a scary time for uneducated investors, but value investors use volatile periods as an opportunity to buy stocks at a discount.
  6. Economics

    Oil Is Cheaper Than Bread In Venezuela...The Country Is In Chaos

    Venezuela is floundering, and the story has more to do with just the falling price of oil.
  7. Fundamental Analysis

    Emerging Markets: Analyzing Chile's GDP

    Chile has become one of the great economic success stories of Latin America.
  8. Mutual Funds & ETFs

    3 Strategies for Trading Mutual Funds

    Learn some of the most commonly used investment strategies employed by mutual fund managers or that can be employed by individual mutual fund investors.
  9. Economics

    Explaining Economic Integration

    Economic integration reduces or eliminates trade barriers among nations, and coordinates monetary and fiscal policies.
  10. Investing News

    Thursday Intel: Yellen on Rates and More Macro Data

    Today should be a packed day as a raft of economic data is expected, and Janet Yellen's speech should keep traders busy.
  1. Discounted Cash Flow (DCF)

    Discounted cash flow (DCF) is a valuation method used to estimate ...
  2. Deficit

    The amount by which a resource falls short of a mark, most often ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods ...
  4. Monetary Policy

    Monetary policy is the actions of a central bank, currency board ...
  5. Cost, Insurance and Freight - CIF

    A trade term requiring the seller to arrange for the carriage ...
  6. International Monetary Fund - IMF

    An international organization created for the purpose of standardizing ...

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!