Inflation and Investing

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Inflation and what it means for investing is one of the biggest issues I have been hearing about recently. The topic can generate quite a bit of anxiety. But before we start to worry, let’s take some time to understand what actually happens when inflation hits the economy. Then we can panic—or not.

Advantages of Rising Prices

What is inflation? At its base, inflation is rising prices. From a company’s perspective, rising prices can be a good thing. Sales, after all, are prices times the number of widgets sold. If the number of widgets sold remains the same—a big if!—rising prices mean higher sales. In fact, many companies grow earnings just this way, by slowly raising prices over time. Revenue management is a dance between raising prices and maintaining demand, and inflation can actually make it easier to raise prices. If demand is strong, as it is right now, companies can raise prices—and sales—without hurting demand. And that is what we are seeing.

Rising Costs and Rising Earnings

Even if inflation means sales are increasing, it also means companies must deal with rising costs. But looking at the numbers, we can uncover advantages here as well. Other things being equal, if sales and costs increase by the same percentage, the company’s profit will increase because sales are larger than costs. For example, if sales are $100 and increase by 10 percent, sales will be up by $10. If expenses are $80 and go up by 10 percent, they will increase by $8. The total profit will increase by $2, from $20 to $22, on sales of $110 and expenses of $88. So, if expenses increase at the same rate as sales, profits can go up.

But, generally, expenses don’t increase at the same rate as sales. Some expenses do, of course, but costs like rent, supply contracts, wages, and equipment are typically contracted over one-year to multiyear periods. Because a significant part of a company’s costs are typically sticky, expenses will increase more slowly than revenues. Eventually, costs will catch up, but for a while the company’s revenues will go up faster than the expenses.

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