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Inflation - Your friend or enemy?

Jul 20, 2009

When you are in the stock market buying stocks for the long run, the above can be quite a tricky question to answer. That is because how much damage inflation does to you depends a lot on what kind of business you are invested in. There are many aspects that go into determining whether a particular business is a good or a bad investment. But looking at it from the perspective of inflation, one important factor one can look at is what kind of returns the company makes on the tangible assets employed in the business. In its simplest form, when anyone starts a business, one has to invest in tangible assets that will be used to run the operations of the company. Tangible assets are those assets of the company that can be touched, seen and felt, like buildings, machinery, inventory, cash, furniture etc.

If you get into the cement business, you would have to buy cement plants to make the cement that you can sell. If you get into the chocolate business, you would have to buy the plants and equipment that makes chocolate. So you buy all the assets needed to make the cement or the chocolate, start selling them, and are happy with the profits either business is earning you. But it is a fact that all businesses are not made equal. Depending on many different factors, some businesses are more profitable than others. And one way of measuring the profitability of the business is its return the tangible assets invested in the business.

Going forward with our earlier example, let's assume that the cement business is able to achieve, on an average, return on tangible assets of 10%, and the chocolate business of 25%. So, the cement business earns net profits of Rs 1 m on Rs 10m of tangible assets, and the chocolate business - Rs 1 m on Rs 4 m of tangible assets. All assets undergo wear and tear, and therefore, after their useful life is over, have to be replaced with new assets. Say for example the life of the plants of both the businesses is 10 years, and in that time prices of everything triple due to heavy inflation.

Going by that, the profits of the two businesses will also triple (assuming the businesses sell the same number of units and have the same margins ten years later), as the prices of cement and chocolate also triple during the time.

But now that the life of their plants and equipment is over, and the time comes for them to be replaced, the chocolate business has to buy the new plant for 4 x 3 = Rs 12 m. Thus to maintain the same level of business, the chocolate company will have to invest Rs 12 m 10 years later. But what about the cement company? To achieve the same level of profits as the chocolate business 10 years later (of Rs 4 m), it will have to invest 10 x 3 = Rs 30 m!

As the years go by, and governments around the world keep printing money for humungous bailouts and stimulus packages, inflation is almost sure to be one of our biggest enemies going forward. But the above article shows how by choosing the right kind of business to be invested in, one can to some extent lessen the damage inflation does. So the next time you pick up an annual report of a company you own, add up all its tangible assets, divide its net profits for the year by the tangible assets of the company, and see what kind of returns its earns on them. Then compare it to the similar result of another company, and you will know which of those companies will be able to better protect you from the harmful effects of inflation in the years to come.

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