Listener Q&A: Should You Adjust Your WACC for Inflation?

0:00We hear all the time on the news about inflation. We hear grocery prices are crazy because of inflation, gas prices, inflation, blah, blah, blah, blah, blah. All we hear about is inflation and how everything is more expensive. And then we hear all about the Fed. The Fed is raising interest rates again. The Fed's refusing to lower interest rates and blah, blah, blah, blah, blah. it's pretty confusing sometimes to fully track what's going on and we had a great listener question so we're going to answer that question and we're going to dive in to really what's going on behind the scenes with inflation and fed interest rates this show is sponsored by liquid iv as we finally transition out of the indoor hibernation and start spending more time outside Staying hydrated is huge.

0:51For me, spring means I finally get to get back out on the water and spend long hours fishing. But those long, sun-drenched days require better hydration to actually enjoy them to their fullest. Liquid IV helps with that. Liquid IV helps keep you hydrated with a science-backed formula designed with an optimized ratio of electrolytes, essential vitamins, and clinically tested nutrients. And right now, you can get 20 % off your first order with code investing at checkout. Whether I'm traveling for work, spending all day casting a line, or just trying to recharge my social battery on the weekends, I know when I need hydration replenishment.

1:28And it feels great knowing Liquid IV can help boost hydration faster than water alone. It's incredibly convenient to use on the go, especially out on the boat. You literally just tear, pour, and enjoy. My go-to flavor is lemon lime, but they also have great flavors like guava and golden cherry. Before I make any investment in the stock market, I'm always looking for the data, and it goes the same for any product I choose to use. I know I can trust Liquid IV because it's clinically tested and backed by a scientific advisory board, real experts, and real science. Just one stick and 16 ounces of water hydrates faster than water alone.

2:06powered by LIV HydroScience, an optimized ratio of electrolytes, essential vitamins, and clinically tested nutrients that turn ordinary water into extraordinary hydration. You're getting eight essential vitamins and nutrients. It's always non-GMO, which is huge for me, vegan, gluten-free, dairy-free, and soy-free. And if you want to skip the sugar, they have delicious sugar-free options, including white peach, lemon lime, and rainbow sherbet. Liquid IV is science-backed hydration you can trust. Tear, pour, live more. Go to liquidiv.com and get 20 % off your first purchase with code investing at checkout.

2:48That's 20 % off your first purchase with code investing at liquidiv.com.

2:54Stephen:When I first started my business, I remember how lonely and intimidating it was. You have to wear so many hats, you're having to figure everything out on your own, and you're basically learning everything from scratch. How I wish I had Shopify as my business partner when I first got started. Shopify is the e-commerce platform behind millions of businesses around the world, and 10 % of all e-commerce in the US comes from Shopify. Household names like Alo Yoga, Gymshark, all the way to brands that are just getting started. You can get out the word like you have a marketing team behind you. Easily create email and social media campaigns wherever your customers are scrolling or strolling.

3:34Stephen:Best yet, Shopify is your commerce expert with world-class expertise in everything from managing inventory to international shipping to processing returns and beyond. And if you're stuck, Shopify is always around for award-winning 24-7 customer support. Start your business today with the industry's best business partner, Shopify, and start hearing Sign up for your one day per month trial today at shopify.com slash beginners. Go to shopify.com slash beginners. That's shopify.com slash beginners.

4:24Stephen:conviction to buy wonderful businesses and stick with them. Your path to financial freedom. Start now. Okay, so welcome back to another episode of Investing for Beginners. Today, we are answering Passaro94's question from Spotify. Thank you for leaving that question. And also, if any of y 'all have questions, please, please, please, whatever platform you're on, drop them in. It makes it easy for us because then we don't have to create content. We just answer your questions and that makes for an easy day at work. So anyway, the question is, when you talk about the inflation impacting the value of a company, would you consider it while making a whack calculation, adding a stable growth rate of two to 2.5 % according to the Fed goal?

5:14Love the podcast and it has been a huge part of my company for a while. and i think he meant keeping him company um but no that's a great question and i'm really looking forward to getting into it because i think i'm going to learn a lot today because andrew knows whack is not my strong suit um so this is going to be fun but andrew before we get into all that stuff um one of the things that you taught me very early on when i started working with you was that inflation never actually goes down. Do you remember that conversation?

5:55Stephen:I don't, but to date, it has not gone down, and that's made for a healthy economy. Right, so yeah, you were explaining to me that to date, as you said, it's never actually gone down. The economy just catches back up to it, and so that's why it feels stable. But yeah, inflation, like saying inflation is going down is actually kind of misleading, I guess you could say. So if you could explain to me, Andrew, one, why doesn't inflation ever go down? And two, why is that good for the economy? These are hard questions, first off, but I think they're worth talking about. One of the quotes that I remember hearing over and over again, and we haven't heard it much because the market hasn't been super hot lately, but people used to always say, don't fight the Fed, don't fight the Fed.

6:52But this idea that what the Fed is doing is their actions power economic growth and also power the stock market.

7:04Stephen:And that's true. And sometimes it has bigger impacts at times than other times. I think it's important to distinguish, though, when we talk about the Fed, the Federal Reserve, what that is, is actually a group of central banks. And so even though the Fed chair is commissioned by the president, the Federal Reserve is a separate entity from the government. So I think a lot of people get that confused and they just call, oh, because it's the Fed, this is the government doing this thing. It's not really. Actually, the Fed is designed. They have what's called a dual mandate. So they need to keep inflation between 2 % to 3%.

7:42Stephen:That's their target. While also making sure that we have some sort of economic growth. And it's tough for them to balance that. And one of the biggest levers, so they have like different tools at their disposal and they'll use that different times. And in crisis, they'll step in and they've done creative things with their balance sheet to help the economy in times of stress. Cause that's really what they are. They, they need to be out of all their mandates. They're kind of like that entity that's going to act when things are breaking down and they, and they, you can argue whether it was a good job or a bad job.

8:23Stephen:I don't win very many points or votes out there by saying like the Fed did a great job in 2020 injecting all this liquidity into the economy because we all feel the inflation years later. But if they hadn't intervened when the entire economy shut down, we could have been in a much worse place and could have gotten into like a deflationary spiral. I think there was actually deflation In the Great Depression time You zoom out long enough There's always inflation But I think Again, don't quote me on it But I think one of the reasons why the Fed is so valuable Is because when we did not have the Fed During bank crises in the early 1900s And the Great Depression That is why you had bread lines people who could not feed themselves for a long period of time because if you have a deflationary spiral that is so so bad for the economy i think that's funny because you and i have had lengthy debates about the fed uh whether or not they did a good job

9:38unfortunately i feel like i lose those debates but i i still uh not a huge fan but that's besides the point um you said in 2020 they stepped in and they really prevented a massive crisis and i think that is one thing like the average consumer may not realize is yes we are experiencing really bad inflation right now because of what they did but because of what they did like you said stop deflation or even worse a depression so real quick what's the difference obvious and i feel like it's self-explanatory but i don't want to miss just in case someone is a little confused because deflation isn't very well isn't talked about a lot uh can you just real quickly explain what deflation is bitcoin is is actually an example of a deflationary asset

10:39Stephen:so in inflation our dollars are less valuable over time deflation is the opposite so your dollars are more valuable the price of everything else is falling that sounds awesome like i would love to buy a big screen TV for like five bucks. That sounds amazing. But, um, if, if that's the case, why not wait another year and wait till it's$3 or$2 or$1. So, okay. If you're feeling that way of, I never want to spend this currency cause I'm just going to wait for prices to continue to fall. What happens to an economy when everybody's behaving that way? Nobody's spending money. uh our economy is interesting because it's actually this kind of blew my mind more of gdp is fueled by government spending than consumer spending which was weird but i'll have to double check to make sure that's the case but regardless like i always thought of gdp and the economy is like consumer spending how much are people spending at target and walmart um and actually a lot of gdp is also just government payments to people so while consumer spending is not everything it's still you can imagine what would happen to our economy if nobody's spending it would be very very bad yeah and to that point andrew correct me if i'm wrong while the cost of that tv has dropped to five dollars the price to manufacture it did not drop with the with the price of the tv so the that ends up costing companies money to make the exact same product they're they're now losing money they're no longer profitable causing them to go out of business causing them or go bankrupt because costing people jobs and then it quickly spirals into a depression if we don't get that deflation under check really quick yes yeah very good points so moving on from from deflation and inflation uh what was it that the fed did in 2020 that in your opinion what really saved us uh from going down that spiral because i mean if you think about it we were primed for a for a nasty nasty fall in our economy because was every, you know, restaurants, how many restaurants had to close, close up shop.

13:12And, and, and, you know, some, unfortunately, some did go out of business, but a lot didn't, they found a way to stay somewhat profitable, um, stay in business at least. Uh, but I mean, unless it wasn't a mandatory job or service, a lot of companies had to shut their doors for a while And not many economies can survive that, and ours did. So what did the Fed do that really paved the road for us to be able to save our economy?

13:45Stephen:They did several things. Let's talk about the big one, because interest rates is when people think of the Fed, they think of interest rates. And interest rates do have a big effect on the economy and also on stock prices. So when interest rates go down in general, stock prices go higher. All asset prices go higher. Real estate goes higher. And that's all in general. We had a crazy period from the 80s until basically 2020 where interest rates just had this nice steady decline from the upper left to the bottom right. And that just drove when people talk about why homes are no longer affordable. That was a big factor.

14:26Stephen:You could just refinance your home every couple of years as interest rates continue to drop. And yeah, just it created so much cash, so much liquidity, just a lot of money just bubbles up and it flushes around in the economic system. So like before I get into, I don't want to turn this into a lecture, so maybe we can make this a little more interactive. Let's talk about, because it's not just one interest rate. There's actually a bunch of interest rates and they all work like a pendulum in normal times. So like, it's been a while since you bought a car, but did you borrow money to get your Jeep?

15:07Stephen:And do you remember what the interest rate on it was? Yes, I did. And my interest rate was, I want to say 3%. Yeah, that's awesome. This was like in 1960 or something. Yeah, just kidding. 2001. Okay. And that was like a five-year loan, probably. Yes. Well, yeah, and I also put$5 ,000 down, and there was hail damage on it. So I ended up buying a brand-new car or a brand-new Jeep for, like,$13 ,500 because of the hail damage. So I put$5 ,000 down, yeah, and plus, you know, my dad had set me up with, oh, what was it called? I don't remember what it was called. But basically, it was this account that, as I worked as a teenager, that helped me start building credit.

16:07So I don't remember what the account was called to save my life. I'll have to ask Dad. But he set me up with that. So whenever I bought the Jeep, I actually had – I didn't have zero credit. So I had pretty decent credit. And he co-signed for it for me. Right.

16:25Stephen:Is your wardrobe well stocked for the upcoming season change? I'm recording and it's the first warm day we've had in a while and I'm realizing my wardrobe isn't as robust as it should be. So I went to Quince and got myself a three pack of 100 % Pima cotton tees. I can't wait to report back to you about how those feel. Quince is all about premium fabrics, considered design, and everyday essentials that feel effortless to wear and dependable even as the seasons change. They are all about quality that lasts. For example, the cashmere is 100 % Mongolian, the same stuff luxury brands use. You know how much we love quality long-term investments on this show.

17:01Stephen:Quince only partners with factories that meet rigorous standards for craftsmanship and ethical production. And again, this stuff looks nice. The cashmere sweater I got back in the winter just had a beautiful color on it. You could just tell it was high quality, and it looked great. Right now, go to quince.com slash beginners for free shipping and 365-day returns. That's a full year to build your wardrobe and love it. And you will. Now available in Canada too. Don't keep settling for clothes that don't last. Go to quince.com slash beginners for free shipping and 365-day returns. quince.com slash beginners.

17:38Stephen:We all know how important it is to make smart decisions in our business, our investments, our finances. Getting the best for less matters. Yet how many of us have looked at our life insurance policies lately? You have to ask yourself, is your coverage enough given all the economic uncertainty? Or are you overpaying? Do you have any new health conditions that you might need to be covered for? I've been putting off looking at my life insurance for too long, but now that's going to change because I'm going to select quote. For over 40 years, select quote has been one of the most trusted brokers in insurance, helping more than 2 million Americans.

18:10Stephen:No medical exam, no problem. SelectQuote partners with providers offering same-day coverage up to$2 million without needing to visit your doctor. Have high blood pressure, diabetes, or heart disease? SelectQuote has partners with policies designed for many pre-existing health conditions so you get the protection you deserve. Get the right life insurance for you for less and save more than 50 % at selectquote.com slash beginners. Save more than 50 % on term life insurance at selectquote.com slash beginners today to get started. That's selectquote.com slash beginners. I just made a new stock the third largest position in my portfolio.

18:48Stephen:And I actually just finished the deep dive report on it called the Newtonian Compounder, How 60 % Returns Power on Unstoppable Machine. It's available for our Value Spotlight members. If you want to see the thesis, we're doing a 60 % discount for now, but I'm pulling the deal once the stock hits$45. Check it out at einvestingforbeginners.com slash 60. So let's say that the credit was a little bit worse. So maybe the interest rate would be like a four or five. So that's the middle of the interest rate curve, five years in that time period, you know, three, four or 5%. If we look at where mortgages are today, I think it's like seven or 8 % for a 30 year mortgage.

19:33Stephen:Sound about right. and then if you look at the uh the rate of a savings account if you're in like a high yield savings account do you have any high yield savings accounts i do not you do not if evan was on the show he would talk probably about three different options but for the longest time uh in the 2010s, even like a CD or a savings account would pay you nothing. So people, obviously, I mean, what happens when interest rates are so low on savings accounts, people did not save much because why would you save if you're getting like half a percent or a percent? So you can see like we have the different durations of debt between like very short term savings account.

20:21Stephen:You have a car loan in the middle and then you have a mortgage at the top. And so in a normal environment, it kind of goes from bottom left to upper right. And what the Fed does is they play with that first immediate rate. They call it the Fed funds rate. So based on what that number is, that can tend to set what happens in your savings account. So when the Fed announces, hey, we're going to do 25 basis points or 50 basis points, we're going to do an interest rate cut and it's going to happen in six months. And then you get an email from like your Ally Savings Account or somebody like that saying, hey, did you know your APY is coming down next week?

21:06Stephen:That's not a coincidence. That's a direct correlation between the Fed setting that entry interest rate and what happens with your savings account interest rate. And then based on where that interest rate is set, it can affect all the other interest rates down the line. Car loans, mortgages, government bonds, which play a big role in the economy and big corporations and the stock market and all of those things, big investors. So by playing with that beginning rate, it can affect everything else. And they have to be very careful with it because what they did in 2020, one of the things they did is they took interest rates to zero.

21:54Stephen:So like, again, a terrible time to have a savings account, but an awesome time to borrow money. I think, I can't remember if it was Apple or Amazon, borrowed like$10 billion for like a percent or something, something ridiculous. Like it's like they're handing out money, right? And so when all these companies can access capital very cheaply, They can do things like reinvest in their company. They can hire. They can do all these things. And it all just amplifies into the economy. So they have to be careful, though, because if they kept interest rates too low for too long, then you get inflation start out of control.

22:35Stephen:Because the thing going back to our conversation you and I had, economic growth and inflation are tied. like you can't break that tie over the long, over the longterm, you can't have one without the other. And so it's, it's one of those things. They just, they basically can't let the economy grow too fast. Otherwise it's going to really disadvantage people who don't benefit from economic growth. So let me see if I can put this in layman's terms for myself. basically the the fed dropped the interest rate to zero what that what that did was it created more money in the market for companies to reinvest which stabilized the economy however when you have too much money in the economy that causes prices to rise out of control which is why we are experiencing a very uncomfortable inflation today beautiful yeah all right we got the message across at least one person understand understood i i'm here to please so i want to switch if i can andrew unless you have something else you want to add on that i kind of want to switch over to um to the effect inflation has on a company.

24:00And we know inflation can cripple companies because, you know, it's running hot on their materials, the goods they need to create their products, raw materials, all that stuff. It's crushing their labor because now they have to give cost of living raises, which most companies do every year anyway. but when inflation is going crazy that that you know what used to be a i don't know what a normal cost of living raise is but we'll say it's 25 cents an hour uh you know now it's it's got to double and go up to 50 cents or whatever so i mean like these these are how or this is how or some of the ways inflation can just absolutely cripple companies.

24:50What assets are not assets. What tools do companies have to protect themselves from things like this?

24:58Stephen:It's a great question. And another one of those topics that is easily misunderstood by investors. When we think of what are the best stocks to buy in a highly inflationary environment, a lot of us go to the minerals and the materials that are skyrocketing in price. So we think of like a gold mining company, or we think of, you know, like a copper mining company, or anything related to these commodities that seem to be going really high up in price. And while, yes, those stock prices can go higher for some period of time, there's also a double-edged sword in what you said exactly, costs going higher, labor, all of the things.

25:41Stephen:And so one of the things, one of the many things that Warren Buffett taught us as investors, taught everybody through his Q &As, is that the way to combat that is actually by being a capital efficient or capital light business. And he always used Seize Candy as a beautiful example of it. Their margins, their capital efficiencies is really great like it doesn't cost a bunch of money to make a chocolate bar they kept their stores very very bare bones if you even want to call them stores they're more like stands they just they're just very efficient and so you pair that with the fact that they had a very great pricing power and and that's really where the separator the differentiator Inflation is like, I don't know, I can't think of something that comes to mind.

26:40Stephen:It's a differentiator. It separates the pretenders from the contenders. It really, the differences in business quality really start to shine. So if you have a competitive advantage, if you have a moat, a structural competitive advantage, and if you have pricing power, you are going to thrive where all the other companies are struggling to make profits. so Seize Candy not only is it capital efficient it also has pricing power dudes are going to buy their he always used the example of Valentine's Day it might have been him or Munger dudes are always going to buy their girls chocolate even if you ratchet it up 20-30 cents they got to get something for Valentine's Day they know the girl loves Seize Candy they're going to pay the extra price so it gives them pricing power and so not only can they make up for the cost increases by increasing in price the cost increases are felt less because the the the margins and and the capital efficiency is um better so so that's that's that's a major way to to handle that so you have to look at the company i like looking at a company and saying what is their pricing power do they have pricing power and if that is the case then i'm not worried about inflation so i'll use uh auto insurance for example that seems to be a topic we keep hitting on for whatever reason can't help it but like you saw the the price of cars go up through the roof you know through 2020 2021 and now you're seeing that continue as people buy more and more of these expensive electric vehicles, an auto insurer has pricing power because they're able to adjust their premiums based on claims paid.

28:27Stephen:So they're like kind of tied to the price of cars in general. So that's pricing power. The entire industry has a pricing power. Whereas something that's a little bit more speculative, maybe something like chicken, you know, like they're going to struggle. Well, chicken's going to struggle with pricing power because at a certain point, if you make my chicken too expensive, I'm going to just buy a bunch of pork. And I know a lot of other people at the grocery store are going to do the same thing. So you see that there's a big difference in what kind of business you're in. And so companies like the auto insurers, the home builders, which is a sad thing to be happy about because it made houses unaffordable for a lot of people.

29:10Stephen:But the home builders, they do great in inflation because they actually are very capital efficient, believe it or not. And they get that overall growth of the economy baked in to their revenues. And they have that. The whole industry has a pricing power. Visa, MasterCard, similar thing. They're attached to the payment rails. So their revenues just naturally go up as the economy grows. Those are the best, probably the best type of businesses to own when you have a lot of inflation. love it and there's one last thing i want to want to touch on real quick before we move on and that's that's the future dollars uh you know a company every company is going to project we're going to make a hundred million dollars in 10 years um but the problem is you know going from so we'll say google like made that projection a hundred million in 10 years and then we hit 2020 and now we're into 2026 with crazy, you know, with higher inflation, suddenly their$100 million isn't as attractive on paper as it was in 2018.

30:20What can companies or what do companies do? What can we look for when it comes to that? Are there any red flags around that we need to be checking on to keep from getting sucked into, oh, that looks great on paper, but then realizing that this future dollar isn't quite what it appears to be.

30:40Stephen:It's another great insight. Analysts, investors, they fall in love with this idea that we're just going to project next year's profits and the year after that and the year after that. And it's like, come on, you got to take that with such a grain of salt and really just put it in its place for what it is. I really think that just this idea of needing to have projections is more of a, it's just people want it more than it actually being accurate in any way, shape, or form. Longer term, having ballpark, I think, helps investors kind of picture. Like if you look at a restaurant stock and they say, hey, we're trying to hit this many restaurants by this day.