CFA Practice Question

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CFA Practice Question

Which of the following is the LEAST ACCURATE with respect to the effects of inflation on asset valuation?

A. The LIFO method of accounting for inventory gives a truer estimate of inventory costs during inflationary periods.
B. Net income computed using conventional depreciation methods overestimate income during inflationary times.
C. In general, the lower the company's flow through rate in passing along the effects of inflation, the higher will be its P/E.
Correct Answer: C

The lower the company's flow through rate in passing along the effects of inflation, the lower will be its P/E. It only makes sense that if a company can not pass on the effects of inflation through its prices, then it is left to absorb the brunt of the inflationary effect on its costs. In other words, with revenues insensitive to inflation and costs increasing with inflation, profits will diminish and so will the P/E ratio.

User Contributed Comments 8

User Comment
jhmorris Since LIFO utilizes the cost of inventory items that are most current (last in), COGS reflects the effects of inflation more directly that FIFO.
VenkatB "A" refers to Cost of goods sold: inventory costs = COGS (not value of ending inventory)
business I dont understand C, the lower the flow through rate, the lower the revenue, the higher the cost, the lower the profits and of course the higher the P/E ratio. If E goes down , P/E should go up.
merc5559 ^ this
sahilb7 @business I agree. Price does not change whereas E goes down. P/E should go up.
davidt876 Price is not a fixed input guys. in most cases when we talk about P/E we're talking about a company whose shares are listed and these shares are valued at market every business day to create P.

Price is meant to be the present value of all future earnings. and in that way it's affected by our expectation for future earnings.

if you can't pass on the inflation effects to your customers, your price should decrease to reflect the negative effect on all those future earnings (provided the high inflation is expected to continue to some degree in the future).

"but dave! if both P and E are decreasing won't P/E stay the same?!"

no. P/E is also a measure of the relative attractiveness of a stock. if you can't pass on the inflation, then investors sell out and look for other companies that can. the company is relatively less attractive at the moment, and this drives down P/E - without even having to consider P or E in isolation we can assume this.

ontop of everything, if inflation is rising, then nominal interest rates are probably rising, which means that the required return on equity (the discount rate for present value of equity) is probably rising. if the discount rate is rising, then this should drive down the market's estimation of the value (P/E) of all stocks (whether or not the company can pass on the inflation)
davidt876 also if you're not sure why B is correct, consider a company buys a computer worth $100 with a salvage value of $10, and inflation is 5%.

depreciable base = cost - salvage = 100-10 = 90

but if you adjusted cost and salvage for inflation:

depreciable base = (cost*1.05) - (salvage*1.05) = 105-10.5 = 94.5

the computer's life in years doesn't change, and therefore the yearly depreciation charge is lower when you ignore inflation -> income is higher (overestimated)

Note: I'm pretty sure for DDB the depreciable base does not consider salvage value. still, the depreciable base will be smaller if you ignore inflation.
UcheSam davidt876 is on point.
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