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Inflation - Implications for stock valuation.

Jun 12, 2000

Inflation is on the rise. And as in case of depreciation in the value of the Rupee, this too seems to have been ignored by the markets. Nevertheless, what does a higher rate of inflation imply for stock markets? First how do investors, assuming they are rational, value stocks? In a discounted cash flow approach one finds the 'discounted' value of all cash flows occurring to them from a company in the form of dividends and other such cash benefits. 'Discounted' here means that since a Rupee now is more valuable than a Rupee one year hence (assuming there is inflation), the future cash flows need to be discounted (reduced in value) by an appropriate rate. Therefore the further down in future you receive the Rupee the lesser its value in current Rupees. The rate at which one discounts the cash flows is the return he or she expects. Now here lies the catch.

The rate at which one discounts the flows depends on, among other factors, existing interest rates and expectations of future inflation. Therefore, when interest rates rise, or one feels that inflation in the future is going to rise, he will naturally up his discount rate. Therefore the present value of a stream of cash flows will be reduced. Thus a stock the looked attractive at, say X Rs, now looks unattractive even though its current market price is the same just because the rate at which cash flows associated with the stock has been raised.

Now what does this imply for the current market situation? Inflation has been rising at a fast pace in recent months. Currently, it stands at 6.59%. Although recently there has been a reduction in interest rates, the rise in inflation has been far greater. Therefore one would expect 'rational' investors to up their discount rates. By this measure a number of stocks that now just about make investment sense, would be pushed into the over valued category.

The stock markets seem to have completely ignored the fact that inflation has been galloping in recent months. Maybe they are hoping that the effect of rise in oil prices will ware off (it probably would not anytime soon), thus bringing down the inflation number. It may also be that markets have once again (earlier being the depreciation in the value of the Rupee) ignored a key economic variable.

Well, it is difficult to suggest when rationality will return to the bourses. But one thing is for sure - it will, sooner or later.

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