In his 1977 Fortune article, How Inflation Swindles the Equity Investor, there’s a section titled – The investor’s equation in which Warren Buffett delivered a sobering analysis of how inflation and valuation affect investment returns. More than four decades later, his insights remain just as relevant.
Buffett makes it clear that an investor’s return is dictated by three key factors: “the relationship between book value and market value, the tax rate, and the inflation rate.”
While many investors focus on the nominal returns of their holdings, Buffett urges them to consider the mechanics behind the numbers.
His example is simple yet profound. If a stock trades at book value—say, $100 per share—its 12% business earnings translate directly into a 12% return for the investor. “If the payout ratio is 50 percent,” he explains, “our investor will get $6 via dividends and a further $6 from the increase in the book value of the business.”
But when market prices exceed book value, returns diminish. A stock trading at 150% of book value results in a lower total return—just 10% instead of 12%—because appreciation is diluted. Conversely, buying below book value amplifies returns, allowing investors to earn a total of 13.5% in Buffett’s example.
The lesson? Investors must be mindful of valuation. As Buffett puts it, “You do better by buying at a discount rather than a premium, just as common sense would suggest.”
He also points to history, reminding readers that valuations fluctuate widely. In 1974, the Dow traded at just 84% of book value; by 1965, it soared to 232%.
“Let’s assume that in the future the ratio will be something close to 100 percent,” Buffett posits, suggesting that in an ideal scenario, stockholders could earn the full 12% business return—before taxes and inflation take their cut.
Buffett’s analysis serves as a timeless warning: inflation erodes real returns, and valuation discipline is crucial for long-term success. Investors who ignore these principles risk falling into the very swindle he described nearly fifty years ago.
You can read the entire article here:
Fortune – How Inflation Swindles the Equity Investor
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