It’s commonly believed that most companies are able to pass on higher costs from inflation onto consumers, via higher prices. Thus the average stock is seen as relatively inflation-protected.
While this may be the case for the long-term, Mckinsey shows how companies’ cash flows are generally hurt by sudden bouts of inflation; as some believe the U.S. could soon be in for.
Additionally, if a company has any hope of protecting its cash flow, in real terms, against inflation, it has to grow sales faster than (not just equal to) the inflation rate. That’s pretty tough. History shows that few companies are able to do this within high inflation environments, which is why stocks are usually slammed during such periods, according to Mckinsey.
Mckinsey: One likely reason companies destroy value is that they can’t pass cost increases on to customers— or can do so only with a time lag. This problem is especially costly when inflation is high and unpredictable: a half-year delay in passing on 15 per cent inflation implies that revenues are always 7.5 per cent too low, causing margins to plummet.
Another reason could be that managers facing inflation don’t sufficiently adjust their targets for the growth of earnings and sales margins. Keeping margins and returns on capital constant in times of inflation means that cash flows and value are eroding in real terms. EBIT growth in line with inflation is also insufficient for sustaining a company’s value. This is even truer for leveraged indicators, such as earnings per share.
For an academic deep-dive, check out the full report below.