>How inflation can destroy shareholder value? (MCKINSEY)

If inflation rises again, companies will have to do more than just match it to keep up—they’ll have to beat it.

Whatever role low interest rates and high government spending may have played in helping
economies to stabilize during the recent global recession, they now have companies, investors, and policy makers alike on the lookout for inflation to come roaring back. Some economists are already warning of a return to the levels of the 1970s, when inflation in the developed countries
of Europe and North America hovered at around 10 percent. That’s not uncommon in Latin America and Asia, where emerging economies have seen double-digit inflation for many years.

At first glance, the effects of inflation on a company’s ability to create value might seem negligible. After all, as long as managers can pass increased costs on to the customer, they can keep inflation from eroding shareholder value. Most managers believe that to achieve this goal, they need only ensure that earnings grow at the rate of inflation.

Yet a closer analysis reveals that to fend off inflation’s value-destroying effects, earnings must
grow much faster than inflation—a target that companies typically don’t hit, as history shows. In
the mid-1970s to the 1980s, for instance, US companies managed to increase their earnings per
share at a rate roughly equal to that of inflation, around 10 percent. But to preserve shareholder
value, our analysis finds, they would actually have had to increase their earnings growth by
around 20 percent. This shortfall was one of the main reasons for poor stock market returns
in those years.

Not just a rising tide
Inflation makes it harder to create value for several reasons, especially when its annual growth rate exceeds long-term average levels—2 to 3 percent— and becomes unpredictable for managers and investors. When that happens, it can push up the cost of capital in real terms1 and lead to losses on net asset positions that are fixed in nominal terms. But inflation’s biggest threat to shareholder value lies in the inability of most companies to pass on cost increases to their customers fully without losing sales volumes. When they don’t pass on all of their rising costs, they fail to maintain their cash flows in real terms.

To read the full report: INFLATION