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Inflation, Rational Valuation and the Market MARCH/APRIL 1979 FAJ by Franco Modigliani cind Richard A. Cohn Inflation, Rational Valuation and the Market • The ratio of market value to profits began a deciine in debt at the inflation rate; the funds obtained from the the iate 1960s that has continued fairiy steadiiy ever issues of debt needed to maintain leverage will precisely since. The reason is inflation, which causes investors to equal the funds necessary to pay interest on the debt commit two major errors in evaluating common stocks. and maintain the firm's dividend and reinvestment First, in inflationary periods, investors capitalize equity policies. earnings at a rate that parallels the nominal interest rate, Rationally valued, the level of the S&P 500 at the rather than the economically correct real rate—the end of 1977 should have been 200. Its actual value at nominal rate less the inflation premium. In the presence that time was 100. Because of inflation-induced errors, of inflation, one properly compares the cash return on investors have systematically undervalued the stock stocks, not with the nominal return on bonds, but with market by 50 per cent. • the real return on bonds. Second, investors fail to allow for the gain to shareholders accruing from depreciation in the real NTIL their poor performance in recent years, value of nominal corporate liabilities. The portion of the equities had traditionally been regarded as an corporation's interest bill that compensates creditors for U ideal hedge against inflation. Equities are the reduction in the real value of their claims represents claims against physical assets, whose real returns repayment of capital, rather than an expense to the should remain unaffected by inflation. Furthermore, corporation. Because corporations are not taxed on that many equities represent claims against levered assets, part of their return, the share of pretax operating in- and inflation is supposed to benefit debtors.' come paid in taxes declines as the rate of inflation rises. Today, the level of the Standard & Poor's 500 stock For the corporate sector as a whole, this effect tends to index, when measured in nominal terms, is approxi- offset any distortions resulting from basing taxable in- mately the same as it was in the second half of the come on historical cost. 1960s. In real terrtls, the S&P has fallen to around 60 If afirm is levered, inflation can exert a permanently per cent of its 1965-66 level, or 55 per cent of its 1968 depressing effect on reported earnings—even to the peak. Figure I provides another indication of the mag- point of turning real profits into growing losses. On the nitude of the debacle. Curve 1 plots an estimate of the other hand, a firm that wishes to maintain the same level market value (debt plus equity) of all U. S. nonfinancial of real debt despite inflation must increase its nominal corporations in relation to an estimate of the replace- ment cost of their assets.^ By 1977, the market value of Franco Modigliani is Institute Professor of Economics and all firms represented less than two-thirds of the re- Finance at the Alfred P. Sloan School of Management, Mas- placement cost of their assets, having fallen from a sachusetts Institute of Technology. Richard Cohn is As- ratio somewhat above one in 1964-65. sociate Professor of Finance at the University of Illinois at This article analyzes three possibilities that, singly Chicago Circle. or in combination, could account for this extraordinary The authors wish to express their gratitude to their col- leagues, Benjamin Friedman, John Lintner, Stewart Myers performance. First, we examine the possibility that, and Paul Samuelson, and to William Hicks of Wellington contrary to expectations, inflation has been accom- Management and Glenn Strehle, Treasurer of M.I.T., for panied by a significant deterioration of profits. Sec- their valuable suggestions. They also wish to thank David ond, we consider the possibility that the application of Modest for his help in carrying out the computations and economically sound valuation methods decrees that the Judith Mason for seeing the manuscript through. The Sloan warranted price-earnings ratio (or, equivalently, the School of Management provided financial support for the computations. 1. Footnotes appear at end of article. 24 • FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1979 capitalization factor to be applied to earnings) should of other researchers consistently show that, although systematically decrease with the rate of inflation. This both measures of return to capital—share of value would imply that even when earnings are keeping up added and return on replacement cost—^respond to with inflation, market values should decline in real cyclical forces, neither exhibits a significant trend over terms—clearly a challenge to the traditional view that the postwar period.^ equities' growth in nominal terms fully reflects the rate How can we reconcile these results with the popular of inflation. Third, we examine the possibility that view that profits have been declining steadily over the investors, at least in the presence of unaccustomed and last decade? ° In the first place, both series demonstrate fluctuating inflation, are unable to free themselves that the mid-1960s represented a time of unpre- from certain forms of "money illusion" and, as a cedented return to capital, whether me'asured as a share result, price equities in a way that fails to reflect their of value added or as a rate of rettim. In the perspective true economic value. of the entire postwar period, the last decade is highly The startling conclusion of our research is that, misleading. In the second place, those who stress the while neither the first nor second explanation finds declining profits viewpoint typically measure return to support in the facts or in the theory of rational valua- capital by using stockholder profits (frequently before tion, the third explanation is surprisingly consistent taxes) adjusted for inventory valuation and for depre- with the evidence and can largely account for the ciation at replacement cost. Series 1 in Figure n graphs puzzling behavior of U.S.equities in the last decade. the share of that measure of profits: It does show a Our analysis provides evidence that investors do in fact clearly negative trend that begins accelerating in 1965, tend to commit two major, inflation-induced errors in and it hits its lowest point by 1975. Series 2 shows what evaluating corporate assets: happens if taxes are deducted; the decline is less dramatic, but still clear. (1) They fail to coirect reported accounting profits for the gain accruing to stockholders eis a result of the real Profit series based on stockholder returns have ac- depreciation in nominal corporate liabilities. Because in- quired particular popularity because of their availabil- flation (especially in the U.S.) has tended to produce a ity; they are regularly computed by the Department of commensurate rise in nominal interest rates, it has also Commerce and published in the National Income Ac- tended to reduce accounting profits, even if correctly counts. But they underestimate true corporate profits, measured profits have in fact kept up with inflation. and by an amount that grows larger as the rate of (2) They tend to capitalize equity earnings at a rate that infiation increases. They do so because, as the inflation follows the nominal rate, whereas (as has long been premium needed to compensate lenders for the erosion known to students of finance) the economically sound of real principal rises, interest expense grows larger. A procedure is to capitalize them at the real rate—that is, at the nominal rate less that portion of it representing the six per cent inflation that caused interest rates to rise inflation premium or, alternatively, the compensation due from three to nine per cent, for example, would cause to creditors for the expected real devaluation of their debt interest expense to treble. claims. Thus, even though total return to capital (Series 3, Figure II) remains unaffected by inflation, adjusted The Real Profitability of Corporate Capital profits (Series 2) decline as interest bills increase. But Series 3 in Figure II plots for U.S. nonfinancial corpo- those adjusted profits are not the correct measure of rations from 1950 to 1977 the fraction of value added stockholders' return. That part of the interest bill cor- represented by returns to lenders and shareholders.^ responding to the inflation premium is actually repay- Here total return is defined as adjusted operating in- ment of real principal, which compensates creditors for come (OI)—^the sum of interest plus after-tax profits the reduction in the purchasing power of their claims. It adjusted to eliminate the effect of paper gains on in- therefore represents a use of profits, rather than an ventories and to reflect depreciation on a replacement, expense. rather than a historical, cost basis. Except for a distinc- As long as total return to capital as measured by tive bulge in the middle 1960s, this series can best be operating income does not decline, returns to characterized as trendless. Indeed, from 1975 on, this shareholders as properly measured cannot decline ratio remained at a level not significantly different either, unless the real interest rate rises—something from, and certainly not lower than, that prevailing that surely has not happened in recent years. Indeed, to fi-om the beginning of the 1950s through the first half of claim that inflation has raised the real rate of interest is the 1960s. tantamount to claiming that creditors have in the long A similar picture emerges from Series 2 in Figure I, run benefited from inflation—a view hardly anyone which shows the rate of return on capital computed as would seriously propound.
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