You don't need to have a finance degree to be a successful investor. But, it certainly helps if you have a basic understanding of investment principles and how the economy affects your investments. Inflation affects the prices of the goods and services you purchase. But, it also has an impact on equity prices. 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 take a look at the relationship between inflation and the price-to-earnings (P/E) ratio of stocks.

Inflation and the P/E Ratio

Let's review two of the concepts in this article. Inflation is the general increase in prices within the economy. The price-to-earnings ratio, on the other hand, is a valuation measure showing how much investors𓃲 are willing 🔜to pay for a company's earnings.

For example, if the price of a stock is $50 and 澳洲幸运5官方开奖结果体彩网:earnings per share (EPS) 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 for a share. Inflation is a measure of the rate of price increases in the economy.

Exploring the Relationship

Stable and moderate inflation means a higher probability of continued economic expansion. Modest inflation usually means that the 澳洲幸运5官方开奖结果体彩网:central bank won't raise 澳洲幸运5官方开奖结果体彩网:interest rates to slow 澳洲幸运5官方开奖结果体彩网:economic growth. When inflation and interest rates areꦯ 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.

When inflation is 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 澳洲幸运5官方开奖结果体彩网:rate of return to maintain their 澳洲幸运5官方开奖结果体彩网:purchasing power.

If investors demand a higher rate of return, the P/E ratio must fall. A lower P/E means a higher return so when you pay a lower P/E, you're paying less for more earnings. As earnings grow, the return you achieve ends up being higher. When inflation is low, investor demand is lower and the P/E higher. The higher the P/E, the higher the price for earnings, which lowers your expectations of strong returns.

When inflation is low, the 澳洲幸运5官方开奖结果体彩网: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.

Let's 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 its 澳洲幸运5官方开奖结果体彩网:profit margin, when really the gr💧owth is all inflation's doing. Investors are generally more willing to pay a premium or a higher multiple, for actual growth compared to artificial growth caused by inflation.

Inflation and Stock Returns

Examining historical returns data during periods of high and low inflation can provide some clarity for investors. Numerous studies, including 2020 research from the Journal of Applied Economics, have looked at the impact of inflation on stock returns.

Some of these studies have produced conflicting results when several factors are taken into account, namely geography and period. For example, a 2017 study published in the journal Research in International Business and Finance concluded that expected inflation can either positively or negatively impact stocks, depending on the period, along with an investor's ability to hedge and the government’s monetary policy.

Unexpected inflation showed more conclusive findings—most notably, a strong positive correlation to stock returns during economic 澳洲幸运5官方开奖结果体彩网:contractions, demonstrating that the timing of the 澳洲幸运5官方开奖结果体彩网:economic cycle is particularly important for investors gauging the impact on stock returns.

This correlation is also thought to stem from the fact that unexpected inflation contains new information about future prices. As such, greater volatility of stock movements has been correlated with higher inflation rates. This has played out as well in 澳洲幸运5官方开奖结果体彩网:emerging markets, where the volatility of stocks is greater than in developed markets.

The Bottom Line

History has shown that investors realize this phenomenon and take inflation into account when valuing stocks. As an investor, you'll want to know how inflation affects the performance of the stocks in your portfolio. Knowing this information can help you make some very important decisions about your investments. When inflation is high, P/E ratios are low; when inflation is low, P/E ratios are high.