Spending More for Less: Telling Growth Stocks From Duds in a High-Inflation Setting

The retail sales numbers for the month of March are out, and for the second month in a row, they show declines after being adjusted for inflation.

Retail sales grew 0.5% month over month in March compared to inflation of 1.2%, as measured by the consumer price index, based on data from the U.S. Census Bureau and Bureau of Labor Statistics. This results in an inflation-adjusted retail sales decline of 0.7% for the month. Year over year, March retail sales were up 6.9% compared to inflation of 8.5% for an inflation-adjusted decline of 1.6%.

When everything is going well with an economy, inflation should be consistent with growth in productive output. Inflation rising faster than consumption thus serves as a signal that productive output is the weak link, which is normally the result of rising costs of production (read: gas and transportation). This situation is further confirmed by the producer price index outpacing the CPI at 11.2% year over year, though the month-over-month reading of 1.2% was the same as the CPI.

In this difficult environment, investors need to be wary of conflating inflation with real business growth. If inflation is 8% but a business only grows its profits by 5%, is it really coming out ahead?

To help distinguish the companies that are actually growing from the ones that only seem to be growing due to inflation, there are a few references we can use, such as profit margins, return on invested capital versus weighted average cost of capital and the discounted cash flow model.

Please note these are just a few of the many factors investors need to consider when researching investment opportunities. A different approach may be needed depending on the type of company, and there is no substitute for in-depth research. Still, these three measures can be useful reference points.

Profit margins

Profit margins are often considered a handy tool that can help investors see the impact of inflation on a business. If margins are shrinking, it means the company is spending more to earn less (though this won’t necessarily be due to inflation alone).

While there are a great many factors that determine profit margins, they do have something that many other items on a company’s earnings report are lacking: some sort of explanation. Reading through an earnings report will typically yield at least one or two sentences on why profit margins have grown or declined.

Have profit margins increased due to something likely to be temporary or cyclical, such as United States Steel (

X, Financial), which saw its operating margin rise as high as 29% for the third quarter of 2021 on rising steel prices before dropping back to 25% in the fourth quarter? If margin decline was due to inflation, the company will probably state so clearly in its earnings report, like Sherwin-Williams (SHW, Financial) did.

Return on invested capital vs. weighted average cost of capital

A little less straightforward than profit margins, the comparison of return on invested capital and weighted average cost of capital measures how well a company is creating value with its investments in its business.

If the ROIC is higher, it indicates the company is earning more back from its investments than what it paid to acquire the necessary capital for said investments. If the WACC is higher, it means the company’s investments cost more than the profits they return.

When a company is investing heavily in growth, it might not be cause for alarm if its ROIC is temporarily low, but certainly, investors should expect to see this number surpass the WACC for a mature and profitable company. One company that struggled with value creation in 2021 as inflation rose was Amazon (

AMZN, Financial), while Qualcomm (QCOM, Financial) saw greater returns on its investments despite inflation, as shown in the below trailing 12-month chart.

Discounted cash flow

When inflation is high, growth stocks tend to see their prices decline. Their shareholders might complain that they are being “unfairly punished,” but the fact of the matter is, growth stock valuation models rely entirely on predictions of future earnings.

The heavy reliance on predictions means that feelings of uncertainty toward the future will cause investors to de-risk their portfolios by trading growth stocks for those with proven profitability. Moreover, inflation is often used as the basis for the discount rate when using mathematical models such as discounted cash flow to reach a valuation estimate. Higher inflation being priced into these models results in a wave of lower price targets.

For example, automotive dealership consolidator Lithia Motors (

LAD, Financial) has a margin of safety of 78.90% using a 9% discount rate for the discounted cash flow model. The 9% discount rate comes from the 10-year treasury constant maturity rate plus a 6% risk premium. However, if we were to use a 14% discount rate (8% inflation plus 6% risk premium), the margin of safety would be reduced to 66%.

The drop in fair value estimates from the discounted cash flow and other prediction-based valuation models is even more dramatic with stocks that have little to no history of profitability. For example, if we assume a 50% per year growth rate for Tesla (

TSLA, Financial) for the next decade, a 9% discount rate shows a margin of safety, while a 14% discount rate shows the stock is overvalued.

Takeaway

So how do we interpret these indicators to determine whether a business is growing in an inflationary environment? The first two, profit margins and ROIC versus WACC, can help us understand whether or not a company is struggling due to inflation.

Meanwhile, the discounted cash flow model can tell us two things: 1) how the margin of safety might hold up to higher inflation, and 2) whether the share price of a speculative growth investment is likely to rebound once inflationary pressures ease.