"When market commentators say that equity valuations are likely...

"When market commentators say that equity valuations are likely to decline if inflation is prevalent, there technically is some truth to that statement – if you believe that multiples are in fact a guide to valuation (which they aren’t). It is a mathematical fact that price multiples will decline under an inflationary environment for the simple reason that they are a nominal, not a real measure (which is again a good reason to not put too much faith in them). Allow us to explain.

Let’s say there’s a company earning 10% return on equity, and there’s no inflation – therefore both nominal and real returns are 10%. Imagine this company trades at 10x earnings. Now if inflation appears at 5% and this company has the ability to pass on rising prices to its customers, it can maintain its real return of 10%, but its nominal return is now 15%. As the real return is still the same the company should still trade at the same multiple: 10x.

However, what has happened to the multiple calculation is that the denominator of the P/E is now 5% larger. So, all else equal the stock that was trading on 10x earnings now sees its valuation drop to just 6.7x earnings. The company is the same, its real cash flows are the same – but it appears to the market to have significantly de-rated. In reality, people should calculate ‘real’ PE ratios, but almost nobody does because as always, the market loves a shortcut."

interesting comments, relevance to REA given its pric8ng power?