High inflation is a problem that all of us are facing. We’ve hit an inflationary trend that we last saw in the late 1970s and early 1980s. The question that I continually get asked is, “how does inflation affect investments?”. Many people are aware of the resulting rise in the price of food and everyday items. However, they are unsure how this may affect businesses and investments.
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Inflation and the Pizzeria Chain
Let’s take a look at a hypothetical scenario.
Imagine you have a growing chain of pizzerias. It’s a hip joint, with tasty toppings and excellent services everyone in town loves.
Inflation is at 0% and people are spending as if money is growing on trees.
Each year you sell $10M in pizzas.
From that $10M in pizza sales, you take home $1.5M as profits.
Here’s what your Profit & Loss (P&L) would resemble:
Annual Revenue: $10M
Annual Costs: $8.5M
Annual Profits: $1.5M
You can take home $1.5 million yearly as long as inflation remains at 0%. This is a fantastic, dependable source of income.
Being the responsible business owner you are, you pay attention to what is happening with economics. You know that inflation is a potential headwind to your business and requires your attention from time to time – so you stay ahead of it.
Your goal is slowly increasing prices once or twice a year in the event inflation starts to rise.
Your customers love your quality, prices, and your speedy deliveries. You have strong pricing power in your city, making your price changes seemingly unnoticed. But accelerated inflation can have a considerable consequence, especially when small margins are at play.
The big problem with inflation is capital costs.
Pizza shops require inventory (flour, beer, toppings) and fixed assets (ovens, mixers, delivery vehicles, refrigerators, etc.).
The costs of purchasing new inventory and replacing old equipment also continue to grow as inflation increases. These items are not optional costs for the business.
Every dollar of additional capital that must be put in will not be there to take out as profits.
Here’s a better way to look at it:
Your pizzerias have $7M of your capital invested into them. This amounts to $0.70 of capital for every $1 of revenue. ($7M / $10M revenue)
From this $7M investment, in a typical year, you are able to profit $1.5M.
Profiting $1.5M per year on a $7M investment equates to a 21.4% return ($1.5M / $7M). Not so bad, right?
When Inflation Strikes
When inflation is 10% a year, the $7M in capital that you typically need will balloon to $7.7M (+10%).
Capital increase costs eat directly into your profits. For example, suppose your pizzerias continue to bring in $1.5M of profits and you now have additional capital costs of $700K (+10% increase). In that case, your profits will now be reduced to $800K. ($1.5M – $800K)
The kicker – the 10% inflation is eroding the value of the $800K by 10% – thus leaving us with ~$720K compared to the previous $1.5M per year. These are the inflationary affects that not only bring the prices of goods and services up, but also reduces the value of the dollar.
Now you’re earning $720K / $7.7M. The inflation increase of 10% has brought down your real returns to 9.35% from 21.4% in the previous year.
So how do you defend your business from inflation?
There are two characteristics of a business that can carry it through rough inflation periods:
- Low capital needs
- Pricing power
Minimizing Cash Needs to Fend Off Inflation
Businesses that can pivot their operations faster than others have a significant competitive advantage. This characteristic is usually found in smaller businesses. During a strong economy, inflation typically remains at lower levels allowing companies to take advantage of growth opportunities by reinvesting profits. Managing capital expenditures (CapEx) is the prime way of achieving growth or minimizing costs.
Warren Buffett advocates separating capital expenditures into two sections; maintenance and growth. Maintenance are the mandatory expenses that must be spent to “maintain” earnings. In comparison, growth is “extra” capital invested to increase the business’s future revenue.
Using this idea, a company must continue optimizing operations and reducing maintenance costs regardless of the economic scenario.
Then, when economic conditions are less favorable for the business, the company can quickly make changes by eliminating the growth CapEx. Making transitions like this are much faster for companies that are smaller in size, and harder for large companies.
The easiest ways for companies to reduce the growth CapEx is by reducing head counts in the company – ie. layoffs. This has been one of the large themes of late 2022 and early 2023 with companies such as Twitter, Meta, Google, and Amazon laying off thousands of employees.
Using Pricing Power to Curb Inflation
Most businesses rely on purchasing raw materials or goods from suppliers and then selling the finished goods to customers. Over time, good business leaders develop great relationships with suppliers and customers. The gross margins of the business heavily rely on the pricing power of the business.
Apple is a perfect example. Apple can continuously release new devices that its loyal customers will continue to purchase at increased prices. Most customers care more about the product than a slight price increase and are willing to pay. In 2018, the gross margins were about 38%, whereas in 2022, they are around 43%. That’s a significant increase in margin on the largest scale business. This is simply due to the pricing power that Apple has earned over its years of building great products and keeping its loyal customers happy.
The Prepared Pizzeria Owner
As an intelligent pizzeria owner, you know how to stay ahead of inflation. Knowing that inflation is continuing to creep up, you make the rational decision to cease expansion costs until the economy improves. This is fine for you, as you’re still small enough to make these changes company-wide.
Several years into the business, you’ve found great vendors that supply you with everything you need to run your company. In addition, you’ve negotiated fair prices for your primary raw materials for the remaining year, so you don’t have to worry about them getting out of control.
Similar to your supplier base, you have built a loyal customer base that loves your business. Like Apple, you have pricing power by offering your customers excellent pizza, a great environment, and speedy deliveries. Incremental pizza price increases to curb costs won’t deter your customers from visiting your pizzerias.
Inflation may slow you down, but it won’t put you out of business.
Conclusion
High inflation can significantly affect businesses’ earnings, ultimately leading to lower profits. Large corporations start to feel the effects of lower operating margins. This is due to the high costs of goods and higher wages. If interest rates change to curb inflation, it will also increase the cost of capital for businesses, which will slow down growth. Eventually, sales will also begin to decline.
Publicly traded companies on the stock market tend to get noticed first. Earnings begin to shrink, resulting in lower price multiples (P/E ratios) paid by investors. This leads to lower stock prices. As this happens, investors’ portfolios begin to shrink, and spending also tightens. This trend slowly makes its way around all markets.
Paying attention to the economy and understanding economic changes can give you a sense of what may come. Staying ahead of inflation and economic uncertainty is imperative to surviving and thriving in a downturn. These same principles apply to business owners and investors alike. Companies that have strong pricing power and low capital needs are able to maneuver through downturns better than those that do not. Understanding these dynamics within a business is crucial when making an investment decision.
Frequently Asked Questions – FAQ
What is CAPEX?
CAPEX, or capital expenditure, refers to the funds used by a company to acquire, upgrade, and maintain physical assets. This could include property, industrial buildings, technology, or equipment. CAPEX is crucial for companies to maintain their operational efficiency over the long term.
How does CAPEX affect a company’s financials?
CAPEX is considered an investment and is, therefore, a cash outflow in the company’s cash flow statement. However, instead of being fully expensed in the year they were incurred, these costs are capitalized and depreciated over their useful life. This practice spreads out the cost of the asset over several years on the income statement.
What is inflation?
Inflation is the rate at which the general level of prices for goods and services is rising and subsequently, purchasing power is falling. It’s usually measured as an annual percentage increase. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
How does inflation affect businesses?
Inflation can have a mixed impact on businesses. On the one hand, it can increase the cost of raw materials, which can squeeze profit margins if these costs can’t be passed on to customers. On the other hand, in a growing economy, a moderate level of inflation is normal and can indicate that demand is strong, which can be positive for businesses.
What is pricing power?
Pricing power is the effect that changing the price of a product or service has on the demand for that product or service. It refers to how much a company can raise prices before customers start buying alternative products or services. Companies with strong brands, unique products, or dominant market positions often have significant pricing power.
How is pricing power related to inflation?
During periods of inflation, costs for raw materials and labor often rise. If a company has strong pricing power, it might be able to pass these costs onto its customers by increasing prices. If not, its profit margins could be squeezed. Therefore, pricing power can be an important factor in a company’s ability to maintain profitability during periods of inflation.
How can a company increase its pricing power?
A company can increase its pricing power by differentiating its products or services, building a strong brand, developing customer loyalty, and reducing its dependency on price-sensitive customers. Market dominance, either through scale or through controlling key resources, can also lead to increased pricing power.
How does CAPEX influence pricing power?
CAPEX can influence pricing power indirectly. A company that makes smart investments in capital expenditure might improve its products or services, increase efficiency, or create new, innovative offerings. Each of these can lead to increased differentiation and, therefore, increased pricing power.
How can a company maintain its profitability during periods of high inflation?
Companies can maintain profitability during high inflation by increasing efficiency, reducing costs, investing in innovation to create more competitive and attractive products, and leveraging their pricing power to pass on increased costs to customers. Effective management of CAPEX is also crucial, as it helps to ensure long-term profitability and sustainability.