Question

. Consider a firm for which the nominal required rate of return is 8%. the rate of inflation is 3%. compute the P\E ratio of the firm under the following situations: i. the firm has a full inflation flow- through. ii. The firm can pass only 40% of inflation through its earnings. iii. the firm cannot pass any inflation through its earnings. what pattern do you observe from you answers to items (i) through (iii)?

Answer 1

As a first step let's figure out the real required rate of return.

Nominal required return, R_nom = 8%

Inflation rate, I = 3%

Real required rate of return, R_real will then have the following equation:

1 + R _nom = (1 + R_real) x (1 + I)

Hence, R_real = (1 + R_nom) / (1 + I) - 1 = (1 + 8%) / (1 + 3%) - 1 = 4.85%

We now need to compute the required rate of return at different levels of inflation pass through to earnings. Let the pass through fraction be "f" then

Required rate of return, R = (1 + R_real) x (1 + f x I) - 1

and P/E ratio = 1 / R

Part (i)

If the firm has full pass through of inflation, then f = 100%

Hence, R = (1 + 4.85%) x (1 + 100% x 3%) - 1 = 8%

And hence, P / E = 1 / R = 1/8% = 12.5

Part (ii)

f = 40%

Hence, R = (1 + 4.85%) x (1 + 40% x 3%) - 1 = 6.11%

Hence, P/E = 1 / R = 1/6.11% =  16.36

Part (iii)

f = 0%

Hence, R = (1 + 4.85%) x (1 + 0% x 3%) - 1 = 4.85%

Hence, P/E = 1 / R = 1/4.85% = 20.62

Lower the pass through of inflation to earnings, lower is the required rate of return and hence higher is the P/E ratio.