Does inflation erode stock earnings or are stocks a good inflation hedge? - Intelligent Investor Book Question

Question

I've come across this in the beginning of the book "The Intelligent Investor", by Benjamin Graham:

How well did Graham’s forecast pan out? At first blush, it seems, very well: From the beginning of 1972 through the end of 1981, stocks earned an annual average return of 6.5%. (Graham did not specify the time period for his forecast, but it’s plausible to assume that he was thinking of a 10- year time horizon.) However, inflation raged at 8.6% annually over this period, eating up the entire gain that stocks produced. In this section of his chapter, Graham is summarizing what is known as the “Gordon equation,” which essentially holds that the stock market’s future return is the sum of the current dividend yield plus expected earnings growth. With a dividend yield of just under 2% in early 2003, and long-term earnings growth of around 2%, plus inflation at a bit over 2%, a future average annual return of roughly 6% is plausible. (See the commentary on Chapter 3.)

It looks like in the first bold sentence, inflation is taking from the stock's returns, but in the second it's being added!

Could you help me make sense of this?

Thank you for taking the time to read so far :)

Answer 1

In the second bolded statement the returns are being broken down into the dividend yield, the company growth and inflation. This is why the 2% dividend yield plus 2% inflation plus 2% company growth makes the 6% total. Inflation is the change of the value of money over time so is always part of any return over a period - it is the change in the value of money over that time. That means that the 6% is nominal (with inflation included) return. If the total return were 5% and dividends and inflation were both 2% when the company must have only grown by 1% - the other 1% has been consumed by inflation. If inflation were at 1% and total return back at 6% then (real) company growth must have been 3% (in the starting year's prices).

In the first bolded statement inflation was running at 8.6% which means that, using the same equation as an example, if dividend yield plus company growth plus 8.6% for inflation must be equal to 6% (the nominal return) then the real (after inflation) return is -2.6% because the effect of inflation. Recall that inflation affects the value of all money no matter what you do and is not a return that you receive. In fact inflation erodes the value of money that isn't producing a return - I can buy less with $1 in a year's time than I can now.