Many investors have overlooked the fact that inflation increases companies’ funding requirements for quick assets—cash and accounts receivable. This is true even if the company is able to increase prices right along with costs, and even if the inflation rate is constant, rather than rising.
A convenient way to measure the quick asset (QA) effect is through its effect on distributable income—the amount a company can pay out to shareholders and still maintain its real assets and financing mix. The QA effect reduces distributable income even though it leaves reported net income unaffected. If shareholders are in fact more interested in a company’s power to pay future dividends than in its reported earnings, the difference caused by the QA effect will nevertheless be reflected in share prices. Using 1977 data for the Standard & Poor’s 500 as an example, the author demonstrates that the QA effect on distributable income would be large enough to explain observed price-earnings ratios.