Why Rising Inflation Is Bad For Growth Stocks [How Inflation Affects The Stock Market] - In this video, former Wall Street analyst Justin Oh, from the Couple of Cents channel is explaining why inflation has a negative effect on growth stocks.
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Why does future inflation expectation hurt growth stocks? Doesn't inflation also mean higher prices and hence higher revenues and higher profit? So it means that higher inflation increases. Your your expectations on return right. So when inflation's higher, you need more return, as an investor uh to beat inflation. So if inflation's zero you're just like, i just want a return right to beat a zero percent inflation.
If inflation's like two percent you're like oh, i need four percent to beat inflation. If you need five percent, it's ten percent or eight percent right. So when that grows up right, you just your expected and required return as an equity investor goes up. So i did this a long time ago, maybe in december, when we first started talking about inflation on my channel, where i did a little dcf comparison of a value stock, free cash flow, uh, straight line or growing very slowly over ten years and one that is Zero, zero, zero, zero zero.
Fifty hundred two hundred like a tesla or something like that, where uh, when you discount cash flows out into the future compound interest, does this right? But when compound inch, but when, like you think about it, going backwards of what that this cash flows worth today, it cuts exponentially the other way. So a hundred dollars in ten years is like nothing right. A hundred dollars tomorrow is something right and a hundred dollars. Tomorrow is way more than a hundred dollars in ten years um and that differential changes based on expectations of interest rates into the future, because the higher return - the steeper this this uh um.
This require this compound interest. Calculation gets but the lower the interest rate is the flatter the the compound interest rate gets so so that means that cash flows out here don't lose as much value as they would. If your expected return was higher, i'm kind of butchering this whole thing and going in circles but um. I would just invite you to learn a little bit about the dcf.
Where um i mean it's a simplistic way to think about it. Um, i think uh warren buffett or charlie munger had said at one point that um, if you were buying a company, a 50 billion dollar company uh and wanted a 10 return and that company didn't pay you this year, but would start paying you next year. Uh, that company would need to start paying you like and if they would pay you an annuity into the future, that number would not be 50. It would go to 55 next year if you didn't get it now or 60 the following year, so yeah.
So like really, it's like cash today is worth more than cash tomorrow, that's the reason, so i'm going to pull up something on the screen just to give people an example, a technical example of what you just said, which is brilliant a really good explanation. So from a technical standpoint, this is an example of a very, very simplified ultra simplified dcf and just to show you what justin is talking about. If you look below you can see, the dcf value of this company is 150 billion dollars. 149.. If the only thing i change is i raise the discount rate to 12 across the board for the entire five-year span. It goes to 110 billion. We just lost 40 billion dollars in valuation over a 2 discount increase and that's a growth stock, yeah yeah yeah versus. If it was a value stock, the percentage uh the percentage value it does go down, but much less yeah.
That's, in my humble opinion, isn't a very good answer by Justin. Missed the mark on the question asked. What does 'higher inflation increases the discount rate' even mean? Higher inflation means higher prices and if a company can control it's expenses (relative to today's value), then the profits might keep up with inflation. Because top line is keeping up with high inflation while expenses are relatively flat. Future expectation of returns/discount rate is a classroom example, not a real world one IMHO.
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This is a good basic explanation, but the problem is that discounted cash flow analysis assumes an average interest rate discount over the time period we choose. We do this because, even though we know interest rates will fluctuate over the period we are analyzing, it is impossible to predict what the fluctuations will be and when they will occur. Therefore, our guess as to the average interest rate over time is likely to be more accurate. Nonetheless, it is a guess. Just like our guess as to what the value of the stock will be on any given future date or our guess as to what the rate of inflation will be and for how long, or our guess as to the future return on a value stock. What I am trying to say is any approach to analyzing how best, or where, to invest oneโs money is simply based on our best estimate of future events, and none of us can predict the future with certainty. Therefore, knowing this conventional wisdom is helpful, but not a guarantee of success. The best thing any of us can do is acquire as much knowledge as possible and then use that knowledge to make our best prediction of what will happen in the future. You must than invest based on that prediction. Of course, a knowledge of math and calculation of present and future values based on your predictions is important.
Hey Tom, what if the companies charges more according to inflation? That means revenue will increase the same right?
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Does this apply to profit or revenue? Because mature growth stocks (eg. TSLA) seem to reinvest all their revenue back into the business, and could technically switch at any time to be profitable.
Shouldn't this explanation affect value companies more since businesses with slow growth rate would not even beat inflation?
can i offer a simple explanation? growth/momentum stocks go up in price when inflation is high. low interest rates means more money printing = higher consumer//commodity// & equity prices. but when the cpi reports soaring consumer prices that is its way of shouting to the market "inflation is going ballistic!!" if inflation is running rampant based off the cpi then the fed can step in and hike interest rates & cut back on inflation. when the fed signals to the market that they are going to cut interest rates and hold back on the money printing stocks//commodities//&consumer prices can go back down.
Interesting to see you are together. It would be nice to see if you both can talk about PLTR. As far as I know….Tom likes PLTR but the other guy(sorry…I don't remember his name) doesn't. Sorry not relate to this topic….thanks though.
i sort of get it if inflation was a constant rate, but it changes year to year. so you just rotate into and out of value and growth every year? so if i held Apple since 2000, i should have rotated out of $AAPL and into say, AT&T ($T), a total of 9-10 times between 2000 and 2021? why in the hell for? what about that 36,000% return would be destroyed by rising and falling annual inflation rates? there is no world in which constantly buying and selling and incurring multiple taxable events makes more sense than buying and holding for a 36,000% return. i just don't see it.
That's one of the most discombobulated explanation of inflation affect on equities I've ever heard. Reasons and affects of inflation on growth stocks is a loaded subject however while I get why you chose, for simplicity, to talk about one aspect, interest rates, specifically risk free rates used in valuation, not sure if you even understand what you said. As for the moderator, really…"brilliant explanation"? a frick and frack show… Per the question indicated, Inflation "expectation" is more an anticipation sentiment on the market therefore decline of growth stocks more likely transitory until it does come to fruition and if so, it'll affect all equities. You should have rephrased and redirected the question to "why does inflation hurt equities but growth even more relative to value"… Your video title and the content of your video a disconnect…
Great video! Itโs important that people understand the discounted cash flow model, where one sees the impact of interest ratesโฆ.
Iโm betting on Cathie Woodโs analysis on inflation which is also consistent with the Central Bankโs view. Basically, now is a great time to load up on Tesla.
That's not quite an accurate look at it though. If you only adjust the discount rate, and not what the expected cash flow, then you aren't discounting the expected cash flow any longer. You are discounting the expected cash flow of the non-inflationary assumption.
It would take more work and more assumptions though… So the safer bet would be to keep cashflows the same but change the discount rate.
Yeah, but that's wrong. When inflation hits, your estimation of future earnings has to go up because future dollars are cheaper dollars, so a company should be able to earn more of them more easily, and inflation compounds so the longer it continues the worse the DCF error becomes because your estimations of the potential earnings are that much more off base.
It makes no sense if you think about it. What companies are able to cut costs and raise prices more easily in response to inflation? Victim "value" companies ripe for disruption that haven't innovated in years because they sell lackluster products at low margins in stable markets with no customer loyalty? Or innovative "growth" companies that are already used to innovating and creating exciting new products that customers are willing to pay a premium for and new, more cost effective processes to create those products? I hope you agree that it's the innovative companies that have the edge, so the DCF calculation, if it were a true valuation, should likewise give the edge to the more innovative companies. The DCF calculation favors the victim companies, so you know it has to be wrong.
To a trader it doesn't matter, she's just trying to predict where the herd of investors will go next, so she's not worried about misallocating her funds for long term total returns. But it makes a huge difference for the long term investor that listens to the beat of his own drum and tries to allocate his capital in the companies that are going to be most successful in a multi-year time horizon. He's got to get it right.
I understand this reality but you have to not only think about how much money the company can make but also how effective the company can be at making money with that money. The main problem with value stocks is their lack of ability to deploy capital in effective ways. Even though Coca-Cola makes money today I would much rather own airbnb or Palantir or Tesla for I know they will be much more effective at deploying that capital once they do get it.
I donโt invest in companies that just make money. I need to invest in companies that know what to do with the money that they make to make more money.
So is it the nature of the stocks and growth uncertainty due to inflation what causes growth stocks to not do well?
Could not watch this all the way thru. Some people are just not ment to be public speakers. I'm sure the info he was trying to get across was probably good info..but he stuttered & stammered so much I could not watch it. Terrible presentation. Love Tom but this guest was ๐
In my opinion inflation isn't bad for growth, it's actually quite good. It means that the overall economy is doing quite well, which increases the demand for services provided by growth companies aswell. However, inflation isn't a good thing if it's because of supply chain constraints, but increasing interest rates will do more harm than good in that aspect.
That said, stocks are not the company and the company is not the stock. Stocks will come down if rates move higher, but the underlying business might actually perform better.
Obvious answer to the superchat is a lot of stock is priced into the future already which if you are going to retain a similar multiple to revenue it has less value now.
The explanation on the mechanics was aimless without first pointing out future revenues are already baked into the current price.
I work for a fortune 50 coโฆ.pricing increases across my industry have been communicated to customers. Consumers will feel more of the pain Q3.
Tom, you have, IMHO, the best channel to educate us, fledgling investors, how to make great investment decisions without talking down & using complicated terms. Thanks for your work & constant reference that we have to do our work, our research, & โblah blah MFโing blahโ!
Keep it up sir!
So my only issue with the argument he makes is exactly what Tom affirmed at the video end- by that logic, inflation is bad for ALL stocks because it hurts the DCF model as profits are less. Iโm good with that and agree.
Where I donโt agree is how this narrative that supposedly inflation disproportionately affects growth vs value as is often pushed in the community and certainly in the Media.
I mean basically there are 2 types of companies – those that disrupt and those that are being disrupted. Wealth transfers from those that are being disrupted to those that disrupt
Inflation is also a transfer of wealth (in relative terms), except in this case it is talked about from creditor to debtor, but really itโs from fearful to fearless.
Iโm not the biggest fan of reasoning by analogy, but this is the best way I can think to explain it. If I imagine the transfer of wealth as a river and the flow of water is from high point to low point, the suggestion is that inflation reverses the flow up the mountain, I just donโt buy it. At best inflation is like erosion and makes the transfer of that water downstream easier.
As someone who likes growth and change investing, it's a bit hard to condition oneself into being a value investor. You'd start feeling like a retiree. :S
the technical example is brilliant? brilliant?!?! did you just advertise for free? i think you should monetize that lmfao
High inflation also means higher operating costs for companies especially that produce goods. That eats away at profitability. Which also hurts growth stocks trying to improve profitability.
Excellent little bits of info, that otherwise go undiscussed or missed entirely… But not with Tomstradamus BAYBE!!
Trillions for Banks and Wall Street Welfare, and we won't give the bottom 1% of the Working Poor an increase in minimum wage because that would be inflationary.