With the CPI numbers coming in higher than expected, valuation experts will continue to grapple with how to assess the impact of inflation on their subject companies. During a BVR webinar on this very topic, Aswath Damodaran (New York University Stern School of Business) noted that, “even if you don’t consider inflation directly, it is still affecting your margins and your growth. You have to dig through the layers of your businesses to see how the impact plays out.”

Margin impacts: Margins (current and target) depend on the company’s cost structure. If the company has high gross margins, the cost inputs are low and (if those inputs are not commodities) inflation might not affect the margins. For example, a software company has high margins that can be 40% or 45% steady state for a simple reason: The extra unit of software it sells costs nothing to make. But, if gross margins are low, typically many cost inputs are needed to produce a product or service. For example, an air carrier has many cost inputs that are commodity inputs (such as oil), so its margins will actually get squeezed if there is high and unexpected inflation. “Operating margins capture the profitability of your business model,” Damodaran observes.

Growth/investment efficiency: When inflation becomes high and unstable, individuals and companies do not like to invest long term because it will take longer to recoup that investment. As inflation gets higher and more unstable, long-term investment tends to drop off. Unexpectedly high inflation will hurt a manufacturing company a lot more than a service company, which makes much more short-term investments.

To capture how efficiently a company is delivering growth, Damodaran uses a ratio called sales to invested capital. (Many analysts use return on invested capital, but he thinks that metric is “vastly overrated.”) Sales to invested capital looks at revenues per dollar of invested capital. What does that measure? If you are a more efficient company, you should be able to generate more revenue per dollar of invested capital. Revenue growth margins and sales to invested capital capture the business model for a company. “I challenge you to find me any nonfinancial service company where I cannot capture the business model with those two inputs,” he says.

BVR is making available free of charge a recording of Damodaran’s 77-minute webinar, In Search of a Steady State: Inflation, Interest Rates, and Value; The (Inflation) Genie Escapes the Bottle! You can access it if you click here (login required).