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It's the nature of future earnings vs current earnings and how inflation changes that. Let's say you have two companies: 'Established' that makes $100 million/

It's the nature of future earnings vs current earnings and how inflation changes that. Let's say you have two companies: 'Established' that makes $100 million/year, and 'Growth' that will make $200 million / year in 10 years, but $0 / year today. Let's say both of these facts are 100% certain and that all market participants agree. Finally, we assume all market participants work off of a 20 year investment cycle just to keep things simple. --------- With 0% inflation, both companies are equal over the 20 year lifecycle. However, with 5%/year inflation, the established company comes out far ahead. The $200 million made in year 10 by Growth is only with $122 million (year 1 dollars). So you can see, future money is less valuable in an inflationary environment. In contrast, the $100 million made by Established is worth $160 million in year 10. ------- Once we account for inflation, the growth strategy fails. Alternatively, growth strategy only works in low inflation environments. In high inflation environments, established sources of money and established real estate / factories is better. The growth company promises to buy a factory in the future, but we all know inflation is making that factory more and more expensive, and it's future promise of future money is getting less valuable.

reducesuffering 5y ago
This example is misplaced because it illustrates the wrong conclusion based on an unrealistic scenario and doesn't factor in interest rates. When future earnings are estimated, it's almost never nominal (except for specific big contracts), but in real value. And with a real value future earning, high inflation / low interest rate actually helps it retain value and boosts those future earnings price. Whereas the real value today gets those $100, but has nowhere safe to earn interest and is instead inflated away. So in time of high inflation, low interest like we had, we saw these growth stocks value fly high. But now there's uncertainty where we might shift into the environment of medium inflation, medium interest, which changes how those growth stocks are valued back to normal. I guess ultimately you're assuming interest rates or staying with inflation, but they don't and it's actually interest that's the bigger factor.
- deleted 5y ago
  [deleted]
- dragontamer 5y ago
  Let's use a realistic example then. In 2014, Tesla raised a ton of money from the stock market to build the Model 3 factory / giga factory. Over the next few years, in a low inflation and low interest rate environment, the investors won. The factory was built, and years later the Model 3 was released to the public. ---------- How would things have changed if large inflation occurred in 2015 or 2016? The factory would have cost 5% or 15% more than expected, and the money raised in 2014 may have not been sufficient. The 2014 dollars raised are used to buy a factory in 2015 or 2016. That's just how companies work. If inflation changes the price of the factory years later, that absolutely affects the investors. The 2014 understanding of factory prices would be wrong, revised later and everyone would make less money in the long run. ------ EDIT: With less effective money (due to increased factory prices), the Growth company will either have to raise more money (ie: dilute the shares and split future earnings with more investors), or build a smaller factory (ie: lowering the amount of future production). Either way, the investors would have lost our on future earnings, roughly coinciding with inflation (ie: how much more the factory cost)
fennecfoxen 5y ago
This example is bad because few companies have fixed potential like earning $200M in nominal dollars. More companies will be able to earn $200M (real year-0 dollars). The real change you see is with interest rates rising, the cost of capital also rises (fewer big investors investing borrowed money or using leverage) and safe alternatives become much more readily available (if a bond or savings account pays money it is safe and you earn a return - as opposed to all the 0% real returns you had in the past).
- dragontamer 5y ago
  > This example is bad because few companies have fixed potential like earning $200M in nominal dollars. More companies will be able to earn $200M (real year-0 dollars). This suggestion only tilts the argument into my favor. Apple makes 190 million iphones/year or so. In an inflationary environment, Apple will still make 190 million iphones and probably still sell them all. Those 190 million iPhones will cost 7% more to make, but also sell at 7% higher prices. So we see that Apples expected profits will rise by 7% or whatever inflation is. But the factory loans that Apple bought 5 or 10 years ago are in 2010 dollars and will remain so. We can see that inflation helps established companies regardless. ------- It is the growth companies who don't own factories yet, who are raising money today that get hurt by inflation.
  - fennecfoxen 5y ago
    I'm not against your idea, but your arguments are a little wobbly. > It is the growth companies who don't own factories yet, who are raising money today that get hurt by inflation. Yep. They, too, compete with opportunities like bonds and savings account. > But the factory loans that Apple bought 5 or 10 years ago are in 2010 dollars and will remain so. Lots of companies have issued bonds at very good interest rates. They're not mostly for factories. Apple's been borrowing money at rock-bottom rates to do share buybacks, because the money's basically-free. > It is the growth companies who don't own factories yet, who are raising money today that get hurt by inflation. So how many growth stocks are investing big into building massive manufacturing operations, Elon? I can think of around one, but certainly not Apple.
mahogany 5y ago
> The $200 million made in year 10 by Growth is only with $122 million (year 1 dollars). > So you can see, future money is less valuable in an inflationary environment. In contrast, the $100 million made by Established is worth $160 million in year 10. I'm a little confused by this. If $200 million was projected as the future earnings of the growth company, isn't it likely that that will also change with inflation? In other words, if we think today that Growth will make $200 million in 10 years, based on inputs X, Y, and Z, then aren't X, Y, and Z also affected by inflation in the future, and so Growth would be affected downstream by this? E.g. maybe part of the $200 million projection is that X will spend 20% of funds on Growth. But now we multiply that 20% by the effects of inflation -- (1.05)^10 -- and X has more to spend, and so Growth makes more as well, proportional to the increase from inflation. I guess what I'm getting at is that inflation affects everything. In your example, it's as if Growth has some static 10-year-out contract for $200 million, which feels a little odd.
- bruce511 5y ago
  Except that inflation does not affect everything, or more accurately it affects everything differently. Inflation can be viewed as a change in supply /demand ratios. So car chips supply goes down, demand for cars is constant, price goes up. Lumber Mills closed during lockdown, supply of lumber constrained, demand goes up, price goes up. But the price of lumber, and cars, are not really linked. Yes, some commodities have knock-on effects - food and energy being prime examples - when oil goes up that tends to impact large areas of the economy because large areas have oil in their supply chain. So, whole average inflation is a useful benchmark number, it may, or may not, impact a companies future earnings, or more precisely, it may not impact earnings and costs in the same way.
- dragontamer 5y ago
  Let's continue the example. Established owns a $1 billion factory (equipment and real estate) to make it's $100/year profits. Growth doesn't own anything yet, they have to build that factory before they get their profits. ---------- The $1 billion factory will itself be worth $1.07 billion after 7% inflation, and the $1.14 the year after that (after another 7% inflation).
davesque 5y ago
I'm a layman when it comes to all this. But isn't it true that, when investors think about projected earnings, they are often implicitly thinking in terms of projected value? So when we say that "Growth" company will make $200 million/year in 10 years, isn't that statement already calibrated in terms of how valuable we think $200 million is today? I would expect that any business strategist worth their salt would account for inflation in their projections. If anything, it's the variation in inflation that seems like the risk factor. That could also be accounted for, but only to some degree of confidence.
- dragontamer 5y ago
  You are right that I've oversimplified things, but you are wrong about the effects of my oversimplification. What analysis study is the price of factories and associated costs. A growth company (like Rivian) is buying new factories and on the path to make 200,000 trucks / year. There are discussions about whether or not that will happen, but you can see that the price of those trucks (and the factory equipment to make those trucks) is going to vary by inflation. > I would expect that any business strategist worth their salt would account for inflation in their projections Yes, they do. But when expected inflation __changes__, those effects are calculated to cause a change in prices today. The price of the old factories don't change, they were already bought long ago, and are at worst in the form of a bond (ie: based off of old money from 2014 or whenever the bank gave them that money). The price of future factories goes up.

reducesuffering 5y ago

This example is misplaced because it illustrates the wrong conclusion based on an unrealistic scenario and doesn't factor in interest rates. When future earnings are estimated, it's almost never nominal (except for specific big contracts), but in real value. And with a real value future earning, high inflation / low interest rate actually helps it retain value and boosts those future earnings price. Whereas the real value today gets those $100, but has nowhere safe to earn interest and is instead inflated away. So in time of high inflation, low interest like we had, we saw these growth stocks value fly high. But now there's uncertainty where we might shift into the environment of medium inflation, medium interest, which changes how those growth stocks are valued back to normal. I guess ultimately you're assuming interest rates or staying with inflation, but they don't and it's actually interest that's the bigger factor.

deleted 5y ago
[deleted]
dragontamer 5y ago
Let's use a realistic example then. In 2014, Tesla raised a ton of money from the stock market to build the Model 3 factory / giga factory. Over the next few years, in a low inflation and low interest rate environment, the investors won. The factory was built, and years later the Model 3 was released to the public. ---------- How would things have changed if large inflation occurred in 2015 or 2016? The factory would have cost 5% or 15% more than expected, and the money raised in 2014 may have not been sufficient. The 2014 dollars raised are used to buy a factory in 2015 or 2016. That's just how companies work. If inflation changes the price of the factory years later, that absolutely affects the investors. The 2014 understanding of factory prices would be wrong, revised later and everyone would make less money in the long run. ------ EDIT: With less effective money (due to increased factory prices), the Growth company will either have to raise more money (ie: dilute the shares and split future earnings with more investors), or build a smaller factory (ie: lowering the amount of future production). Either way, the investors would have lost our on future earnings, roughly coinciding with inflation (ie: how much more the factory cost)

fennecfoxen 5y ago

This example is bad because few companies have fixed potential like earning $200M in nominal dollars. More companies will be able to earn $200M (real year-0 dollars). The real change you see is with interest rates rising, the cost of capital also rises (fewer big investors investing borrowed money or using leverage) and safe alternatives become much more readily available (if a bond or savings account pays money it is safe and you earn a return - as opposed to all the 0% real returns you had in the past).

dragontamer 5y ago
> This example is bad because few companies have fixed potential like earning $200M in nominal dollars. More companies will be able to earn $200M (real year-0 dollars). This suggestion only tilts the argument into my favor. Apple makes 190 million iphones/year or so. In an inflationary environment, Apple will still make 190 million iphones and probably still sell them all. Those 190 million iPhones will cost 7% more to make, but also sell at 7% higher prices. So we see that Apples expected profits will rise by 7% or whatever inflation is. But the factory loans that Apple bought 5 or 10 years ago are in 2010 dollars and will remain so. We can see that inflation helps established companies regardless. ------- It is the growth companies who don't own factories yet, who are raising money today that get hurt by inflation.
- fennecfoxen 5y ago
  I'm not against your idea, but your arguments are a little wobbly. > It is the growth companies who don't own factories yet, who are raising money today that get hurt by inflation. Yep. They, too, compete with opportunities like bonds and savings account. > But the factory loans that Apple bought 5 or 10 years ago are in 2010 dollars and will remain so. Lots of companies have issued bonds at very good interest rates. They're not mostly for factories. Apple's been borrowing money at rock-bottom rates to do share buybacks, because the money's basically-free. > It is the growth companies who don't own factories yet, who are raising money today that get hurt by inflation. So how many growth stocks are investing big into building massive manufacturing operations, Elon? I can think of around one, but certainly not Apple.

mahogany 5y ago

> The $200 million made in year 10 by Growth is only with $122 million (year 1 dollars). > So you can see, future money is less valuable in an inflationary environment. In contrast, the $100 million made by Established is worth $160 million in year 10. I'm a little confused by this. If $200 million was projected as the future earnings of the growth company, isn't it likely that that will also change with inflation? In other words, if we think today that Growth will make $200 million in 10 years, based on inputs X, Y, and Z, then aren't X, Y, and Z also affected by inflation in the future, and so Growth would be affected downstream by this? E.g. maybe part of the $200 million projection is that X will spend 20% of funds on Growth. But now we multiply that 20% by the effects of inflation -- (1.05)^10 -- and X has more to spend, and so Growth makes more as well, proportional to the increase from inflation. I guess what I'm getting at is that inflation affects everything. In your example, it's as if Growth has some static 10-year-out contract for $200 million, which feels a little odd.

bruce511 5y ago
Except that inflation does not affect everything, or more accurately it affects everything differently. Inflation can be viewed as a change in supply /demand ratios. So car chips supply goes down, demand for cars is constant, price goes up. Lumber Mills closed during lockdown, supply of lumber constrained, demand goes up, price goes up. But the price of lumber, and cars, are not really linked. Yes, some commodities have knock-on effects - food and energy being prime examples - when oil goes up that tends to impact large areas of the economy because large areas have oil in their supply chain. So, whole average inflation is a useful benchmark number, it may, or may not, impact a companies future earnings, or more precisely, it may not impact earnings and costs in the same way.
dragontamer 5y ago
Let's continue the example. Established owns a $1 billion factory (equipment and real estate) to make it's $100/year profits. Growth doesn't own anything yet, they have to build that factory before they get their profits. ---------- The $1 billion factory will itself be worth $1.07 billion after 7% inflation, and the $1.14 the year after that (after another 7% inflation).

davesque 5y ago

I'm a layman when it comes to all this. But isn't it true that, when investors think about projected earnings, they are often implicitly thinking in terms of projected value? So when we say that "Growth" company will make $200 million/year in 10 years, isn't that statement already calibrated in terms of how valuable we think $200 million is today? I would expect that any business strategist worth their salt would account for inflation in their projections. If anything, it's the variation in inflation that seems like the risk factor. That could also be accounted for, but only to some degree of confidence.

dragontamer 5y ago
You are right that I've oversimplified things, but you are wrong about the effects of my oversimplification. What analysis study is the price of factories and associated costs. A growth company (like Rivian) is buying new factories and on the path to make 200,000 trucks / year. There are discussions about whether or not that will happen, but you can see that the price of those trucks (and the factory equipment to make those trucks) is going to vary by inflation. > I would expect that any business strategist worth their salt would account for inflation in their projections Yes, they do. But when expected inflation __changes__, those effects are calculated to cause a change in prices today. The price of the old factories don't change, they were already bought long ago, and are at worst in the form of a bond (ie: based off of old money from 2014 or whenever the bank gave them that money). The price of future factories goes up.