Why Inflation Hits the High Fliers Hard
Inflation was a huge headwind for investors in 2022, leading to a decline of nearly 20% for the S&P 500, the worst performance since the Great Financial Crisis of 2008.
Inflation reduces the real spending power of households and businesses alike and can cause a reduction in economic activity. It also forces policymakers to raise interest rates, which tightens credit conditions and causes the economy to slow. Plus, higher interest rates make stocks less attractive.
For example, three-month U.S. Treasury bills, considered to be “risk less,” now yield about 4.6%. Since stocks are considered to be risky assets, investors demand a higher rate of return.
The hardest hit stocks have been those considered to be high-multiple, high-growth stocks.
Discounted Cash Flow
A common way to value stocks is to take the present value (PV) of future cash flows. This is done by discounting the future cash flow by a certain discount rate.
One way to think about the discount rate is that it’s the required rate of return. What rate of return does an investor expect to take the risk of investing in a stock as opposed to, say, buying a Treasury bill?
How analysts determine what rate to use in practice is beyond the scope of this article, but the rule of thumb is that when inflation is high and interest rates rise, that discount rate goes up.
Note that the discount rate is compounded by the number of years from now. The longer into the future, the larger the discount factor. For example, at a discount rate of 8%, the discount factor for cash flow in one year is 1.08 (1 + 8%). For two years, it’s roughly 1.1664—(1 + 8%)2.
To discount $100 one year in the future into the present, you would divide the $100 by the discount factor, or $100 ÷ 1.08 = $92.59 today. $100 two years from now would be worth: $100 ÷ (1.1664) = $85.73.
Another way to think about this is, if you invested $85.73 today at an annual interest rate of 8% with compounding, at the end of two years the investment would grow to $100. The higher the interest rate, the less you need to invest today for that money to become $100 at the end.
The PV of cash flows of $100 one year from now and $100 two years from now is $92.59 + $85.73 = $178.32.
The higher the discount rate used, the lower the PV becomes.
You may be wondering at this point, when the discount rate goes up, the PV goes down for every stock. Why would growth stocks be more affected than value stocks?
Larger Future Cash Flow More Affected
In the case of growth stocks, the cash flow is expected to grow significantly in the future. In other words, the company is expected make a lot more money in the future than it does now.
By contrast, for a value stock future cash flow is not expected to differ very much from the cash flow now. A change in the discount rate will affect the larger future cash flow more. The discount factor becomes larger and larger the further you go into the future.
The tables below show how a four-percentage point increase in the discount rate would affect the PV of a growth stock vs. a value stock given the expectations/assumptions outlined in the tables.
A Bird in the Hand…
As you can see, the PV of the growth stock falls by a larger percentage. Furthermore, when high inflation causes economic uncertainty, investors will demand a lower multiple for high-growth stock because their payoff (i.e., strong profits and cash flow) tends to be further down the road so investors have a smaller degree of confidence.
By contrast, companies whose stock is priced like a value play tend to be already making the money now. When inflation expectations go up, money becomes more valuable because inflation erodes the value of future money.
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