The Hindu Business Line : Relationship between inflation and PEM

INVESTORS are now willing to pay higher price-earnings multiple (PEM) for a stock than they did three-four years ago. Apart from better earnings potential, the low inflation condition may be one reason for the investors' willingness to pay higher PEMs. What is the relationship between inflation and the PEM?

The PEM refers to the number of times you are willing to pay per share of earnings (EPS). A PEM of 12, for instance, means that you are willing to pay 12 times for every rupee of earnings.

Now, the EPS is a function of a company's revenue and costs; higher the revenue and lower the cost, higher the EPS.

During a high inflation condition, companies can easily increase their product prices. This ability to easily hike prices encourages less efficient companies to pass on their production inefficiencies to the consumers. This improves the EPS of such companies.

But what if inflation declines later? If these companies continue to remain inefficient, their profitability will be affected. Why? In low inflation condition, companies will be forced to cut their product prices. Naturally, the profit margin of the inefficient manufacturers will be squeezed; their EPS will decline.

The higher profitability that these companies enjoyed during high inflation conditions will, therefore, be transitory.

Investors are aware of this. That is why they are apprehensive of corporate earnings during high inflation condition. In low inflation condition, however, companies have to manage their production efficiently to generate earnings growth. This is because it is difficult to raise product prices. The quality of earnings is, hence, better.

This prompts investors to pay a higher PEM during low inflation condition, even for the same level of EPS.

In other words, inflation and PEM are inversely related; higher inflation leads to lower PEM, and lower inflation to higher PEM.

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