'Uncertainty over inflation kills companies', finance guru Aswath Damodaran explains why

Aswath Damodaran (Illustration by Suneesh Kalarickal)

With inflation soaring to a record decadal high in the United States, investors should talk to people outside the country to understand why high prices can be scary, Aswath Damodaran, a celebrated professor of finance at the Stern School of Business in New York, has said.

"I found it disconcerting that people are so quick to dismiss inflation," he said in a recent podcast, adding, "inflation drives everything we do in markets."

Data released on June 10 showed that the US consumer prices climbed 8.6 percent over the year through May, the fastest rate of increase in 40 years, after rising 8.3 percent

Also read: Here’s what you need to know about America’s super-hot inflation

The deadly inflation

Damodaran breaks down inflation into two components—expected inflation and unexpected inflation.

"Expected inflation is something that we can build into our financial assets... Expected inflation to me is the more benign part of the inflation," he says.

The professor rates the second part, the unexpected inflation, as devastating. "When inflation comes in above expectations, it's devastating, because you never had a chance to build it into prices, you have a mad scramble going on adjusting prices to reflect the new inflation," he says.

Inflation kills companies

Damodaran says that companies can adjust to expected inflation.

"The problem is when inflation becomes higher, it also becomes volatile, which means that when inflation is 10 percent, it's far more likely to be swinging from 4 to 16 than (when) inflation is 2 percent. What kills companies is the uncertainty about inflation," he says.

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"Inflation kills infrastructure companies. It kills companies which make long-term investments because those investments now will either be delayed or not taken when inflation becomes uncertain."

Smallcap vs largecap

Damodaran says that the smallcap premium was the strongest during the high inflation period of the 1970s. "Small-cap companies had more flexibility to adjust inflation and there's a reason why the more established you are as a company, the more your business model has already been set, the more adjustment is involved when inflation hits you because you got to change the way you do business."

"The lesson from the 70s and the 80s is there's really no safe spot among financial assets, but among financial assets, there are relatively less damaged versus more damaged assets," Damodaran says.