Effect on Stock Valuation
Until the 1960s, common stocks were viewed as a good instrument against loss caused by inflation. Also, before 1960, stocks were not providing full hedge against the inflation. The only benefit attached with the investment in the common stocks was that their value was not very adversely affected during the period of inflation and their performance was comparatively better. To understand the effect of inflation on stocks' value, we will now try to evaluate the Gordon-Shapiro dividend discount model.
V0 = D0/K - G
V0 = value at time zero.
D0 = dividends received during time period zero.
K = constant discount rate.
G = constant growth rate of dividends.
According to the supporters claiming that common stocks are good inflation hedging instruments, there will be no change in V0 due to unexpected inflation. This is expected because the discount rate K also increases along with increase in the inflation expectations and the rate of change is almost similar to the dividend growth rate, ‘G'. Hence, the net effect on V0 will be almost zero. However, for this idea to hold good, companies should be able to forward the increase in costs of raw materials, borrowings and taxes in the form of higher selling price of their product.
Stocks are expected to show good gains during periods of unexpected inflation only when companies can increase their selling price at a higher rate than the increase in the cost of materials, labor and other inputs. But, past observed evidence recommends that common stocks have not established themselves as a perfect hedging instrument against unexpected inflation. It is important to mention here that this conclusion is based on a study conducted using pre-tax returns. In fact, the results based on after-tax returns are more remarkable. Now the question arises as to why stocks cannot provide hedging benefit against the unexpected inflation. The real output growth is not resistant to the negative effects of inflation and this ensures that unexpected inflation will damage the value of all the capital assets. Since the income of the common stocks comes mainly from the residual income of the economy, the decline in the value of common stocks is uneven.