 Hello and welcome to the session in which we'll discuss how inflation affect equity investment. First, we need to know what is inflation? Inflation is when the price level increases, the general price level of things increases. Things becomes more expensive. And as a result, inflation erodes, erases, reduce the purchasing power of money over time. So simply put, if you have $100 today, you might be able to buy 50 cups of coffee if the cup of coffee is for $2. However, if you have $100 and the cup of coffee because of inflation is $3, then you cannot buy 50 cups. You might be able to buy how much? What's 100 divided by three? Approximately 33.33 cups, 33 cups. So what happened is your purchasing power, this $100 is buying you less cups of coffee. Now, inflation also affect the investments. And specifically in this session, we're gonna be looking at equity investments, investments in stocks. It will affect investments in the following way. We're gonna have lower valuation. Lower valuation means stock prices go down in value. They are cheaper, but cheaper is not good. Cheaper means they go down in value. We're gonna have a higher interest rate and a reduction in real return. Higher inflation will affect consumer spending and corporate earnings. It will affect certain sectors differently and it will affect investor sentiment. So this is what we're gonna be discussing in this session. How inflation, and specifically when I say inflation, I'm gonna assume inflation going up. Now everything I say about inflation going up, the opposite is true if inflation is going down. If inflation is going down. Let's go ahead and get started by lower valuation. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's gonna help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. What is lower valuation? Well, lower valuation means you are giving the stock a lower price. So inflation can impact the valuation of companies. Companies means the companies are represented by their stock. So the first thing will happen when we have a higher inflation, the Federal Reserve or the central bank of that country will increase interest rate. So what happened when you increase interest rate? Interest rate is the cost of money. So the to conduct business, it's gonna cost you more. It's gonna increase the cost of borrowing. The cost of borrowing means your expenses are going up. And when interest rate goes up as well, your real return, your real return goes down. So let's assume right now you can earn 10% on an investment and the inflation is 4%. So inflation is 4. So your real return is 6%. Let's assume you are still earning 10% but the inflation rate is 6%, 6%. Now your real return is 4%. Real return is the real. It means what you are actually earning because part of that 10%, 6% of it is, is being eroded by the higher inflation rate. And when there's higher inflation rate, the real return goes down because the higher interest rate eats up real return. So this in turn, reduce profitability and potentially decrease equities. And this is what happened when interest rate goes up. When interest rate goes up, the stock prices go down. And we're gonna show you this, why it works that way. And also investors, think about it. When you have a higher rate of return, when you have a higher rate of return, of return and investing in stocks, we will invest in stocks. But when this higher rate of return switch to debt, now you can earn more or almost the same amount of money investing in debt. And that means in bonds. Then what's gonna happen, people would leave stocks and invest in bonds. And as a result, the stock prices will go down. So investors will switch to debt investments as a more attractive option. Now in the next session, we would look at debt investments. We're gonna look at how inflation affect debt investments. So when interest rate rises, we can say, which is, and when I say when interest rate rises, as a result of inflation, it generally leads to lower valuation for financial assets, including stocks, bonds. Bonds means debt investment and real estate. You might be saying, hold on a second. Didn't you say that investors will switch to debt investments? But you're just telling me that that investment goes down. We'll switch to debt investments that are new issued debt investments. It means that that investment's based on the new higher rate. The existing debt investments will go down in value and we'll see this in the next session. But whatever I explain about stocks will apply to bonds. So the relationship between interest rate and the valuation of any asset, whether it's a stock, bonds or real estate can be explained using the discounted cash flow model, which you should know what the discounted cash flow model that I will show you in an example. So let's assume a company is expected to generate $1,000 annual cash flow indefinitely. So we're looking at an indefinite cash flow. And we're gonna assume the current rate, the current interest rate is 5%. And we're gonna assume later that the interest rate went from 5% to 10%. So let's see what's the value of this investment if the interest rate is 5%. When the interest rate is 5%, we compute the present value of the cash stream through the following formula. Cash flow divided 1 plus i. And the value of this company, the value of this investment is $20,000. So at 5% interest rate, we would say this company is worth $20,000. Now, if it has 20,000 stocks, then each stocks is worth a dollar if you wanna make it in terms of stocks. If it has 10,000 stock, each stock is worth $2. So on and so forth. If it has a million stock, you will take the 20,000 divided by the million stock. But the company overall is worth 20,000. Now, let's assume interest rate increases to 10% due to inflation. Now, when we discount the cash flow, we have to use the 10%. Now, if we do the same thing, the cash flow stays the same, plus 1 plus i, which is the interest rate. Now, the value of the company is 10,000. Notice the value of the company was cut in half. So the value of the stock was cut in half. Now, the same concept can be said when we value bonds. How do we value bonds? A bond is composed of two things. You're gonna get your money back, your principal amount, plus you're gonna get a stream of cash flows. Those axes are streams of cash flow, plus your money back. So the value of the bond investments, you will do the same thing. You will take the cash flow divided by 1 plus i. The cash flow 1 plus i raised to the n, whatever the two-period, three-period, so on and so forth. So as i goes up, as you saw as i goes up, the value of the bond goes down. And this is why higher rate would lead to lower valuation. Same thing if you have real-state investment. Well, if you have real-state investments, you are going to get rent, rental payment. So what happened is, as you receive those rental payment, you have to discount them at that rate. So when you discount them at that rate, you will get a lower value. So notice the value of the company dropped. So this is one of the things that could affect the equity investments. Also, when we have higher inflation, it's gonna affect consumer and corporate earnings indirectly. How so? Well, as I told you, inflation can impact consumer purchasing power. Remember the $100 that I had earlier? Now it buys me only 33 cups of coffee versus it used to buy me 50 cups of coffee. So I'm gonna be spending less because if I can only buy 33 cups of coffee, the producer, Wawa, can only sell 33. Therefore, Wawa profit because they're selling less. And I may not even buy the 33 now. I have to cut down because I have to also buy other things because the $100 now can buy me less. So it's gonna erode, it's gonna erase my purchasing power. And if prices rose faster than wages, then consumer will have to cut on spending. So if the inflation is moving higher than my increase in my wages, then I have to cut on spending because I kind of, in a sense, I took a pay cut that affect the revenues and profitability of companies because I'm gonna be buying less coffee and less of other things. And as a result of I'm buying less, lower corporate earning can lead to a decline in the stock price, negatively impacting equity investments. So this is also how inflation will impact equity investments. Now, bear in mind, not all companies are affected the same. Certain sectors are affected differently, okay? So inflation can affect various sectors of the economy differently. Some sectors like commodities and energy may benefit from rising prices because they increase their prices and you have to buy energy, you have to buy certain commodities. While other consumer discretionary, now if you have the option not to buy something, you're not gonna buy it because that's more expensive or technology, you may not buy the latest technology, but you still have to heat your home. You still have to buy bread. You still have to buy corn, but you don't have to buy the latest technology. Therefore, certain sectors are affected differently. Obviously discretionary and technology when inflation goes up are hurt and the opposite is true. So investor need to assess inflation and how it impacts various sectors in which they have equity investments. Also inflation will affect investor sentiment. Why? Because remember, once inflation increases, you have less purchasing power, you can buy less of stuff. So it affect your sentiment, it affect your behavior. If inflation also perceived as a threat to economic stability, it can lead to market volatility. Remember we talked about expectation. Well, guess what's gonna happen? If you expect prices to go up, what are you going to do now? You're gonna buy more. When you buy more, the prices will be higher because there's supply and demand because if that's the case, then it's gonna create volatility and heighted uncertainty. This could also impact equity prices as investors become more conscious because they don't know what's gonna happen. Now, people are buying now, okay? But I'm buying the future. What's gonna happen to the future of they are buying now and putting the prices up? In the future, we're gonna have a large drop when they stop buying. All these, for all these reasons, and higher inflation doesn't bode well with equity. So generally speaking, we can say higher inflation means lower equity investments, and we can say other investments as well, but for debt investments, we're gonna see we have various type of debt investments. Therefore, we have to approach the debt investment separately in a separate recording. That's why I kept it separately. 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