I’ve been thinking a lot about inflation over the past year and how inflation can distort growth. People rarely factor inflation into their rates of return calculation, but they really should. Inflation eats away at our purchasing power and in order for our purchasing power to improve, our returns must exceed inflation. This means that our returns could even be negative and we would still be better off, so long as inflation was even more negative (in other words deflation).

Certainly inflation is an important factor in assessing a potential bond or equity investment as the inflation rate directly influences the price you should be willing to pay. The higher the inflation rate, the lower the price you should be willing to pay. That is because you must generate a higher return to exceed inflation.

I think that there is a parallel concept in share ownership. As a common shareholder I hold a claim against the assets of the corporation. In order for my investment to do well, my claim against the assets must increase in value over time. This means either the value of the assets of the company must increase, or my proportionate claim against the same value of assets must increase (for simplicity we will assume this company pays no dividends, though dividends would not affect this concept). This must happen without any additional investment from myself because any additional dollar I invest is not factored into the increase of value of my original shares.

Let’s use a simple example to demonstrate this concept.

Let’s say I own 20 common shares in Bondco which I paid $20 for. There are 100 common shares of Bondco that are currently issued and outstanding which means I own 20% of the company. In other words, I have a legal claim to 20% of the assets of Bondco. Bondco has no liabilities and its sole asset is a single GIC with a principle value of $100 and which pays interest at a rate of 5% per year (A 5% GIC borders on fantasy at the current time, but it makes the math easier). Bondco does not pay any dividends and retains all of its earnings.

At the beginning of the year the value of my share of the assets would be $20. That’s what I would receive if the company was liquidated. After one year passes, the company will have earned $5 on its assets ($100 GIC x 5%). It will still hold the GIC worth $100 but now it will have $5 in cash to re-invest for a total value of assets of $105. In this simple example we assume Bondco’s costs are minimal so revenue is the same as net profit. Assuming no shares have changed hands during the year, the value of my common shares should now be worth $21 ($105 x 20%).

The value of my shares will have increased by 5%. As long as inflation was less than 5%, I will have gained purchasing power and my investment was a successful one.

Pretty straightforward right?

But now let’s say in the beginning of year 2, that the management of Bondco is seeking to grow the business. They identify a business (Opco) that they want to buy for $110. They are looking to double the company’s revenues. Since they don’t have the cash to purchase Opco they have to look for other sources of capital. They are unable to find a bank that is willing to lend them the $105 they need ($110 - $5 of cash which is retained earnings). So in order to raise the capital they decide to sell an additional 100 shares of Bondco at the current price of $1.05 a share. I don’t purchase any of these new shares and my overall stake in Bondco is therefore diluted from 20% down to 10%. The assets of Bondco are now $210 though so the value of my stake is still $21.

The performance of Opco is much more uncertain then the GIC that Bondco holds. At the high end Opco might return 10% on assets invested. At a low end Opco will return 1% on assets invested. This means the revenue from Opco which can be consolidated into Bondco will be between $1.10 and $11. If you add in the income from the GIC, Bondco’s revenues will be between $6.10 and $16.00.

Either way, the revenues for Bondco are going to grow dramatically. Even in the worst case scenario the revenue growth will be 22% higher in the 2nd year than it was in the 1st year. At the top end the revenue growth will be a whopping 220% over the 1st year. Clearly the company will improve upon its objective to grow the revenues. But will I be better off as a shareholder?

Let’s say Bondco does have problems with integrating its new business Opco and is only able to manage the 1% low end return. Bondco’s revenues will grow from $5 to $6.10. My share of those revenues however will actually shrink, from $1 in the first year to just $0.61 in the second year. In other words, even though the revenues of Bondco have grown dramatically, my share of those revenues has almost been cut in half. The $110 value of Opco will probably shrink now that the revenue it has generated was so disappointing. It’s original $110 value might only be worth $22 now on resale. If that is the case, then Bondco’s assets would now be $128.10 [$100 (GIC) + $22(Opco) + $6.10 (cash from 2nd year’s earnings)]. My claim on the assets of Bondco as a shareholder will have shrunk from $21.00 to $12.81 from year 1 to the end of year 2.

You can see how dilution reduces the value of my shares in a similar way to how inflation reduces the value of my dollars. And just like an investor should factor in inflation when they are assessing an investment, they should also factor in the effects of dilution on an investment. Companies that might appear to have very impressive growth rates might not be so impressive after you’ve factored in dilution of the shares.

A quick example from two companies based in my hometown. The two companies are Boyd Income Fund (BYD.UN) and Exchange Income Corp (EIF). Both have had tremendous growth in revenues, profits and market cap over the past 10 years. Boyd has grown its revenues by an annual rate of 25.04% over the past 10 years, which is very strong growth. Exchange Income Corp has also grown their revenues at a very strong rate of 22.93% annually. As a result of this, both company’s stock prices have performed remarkably well over the past 10 years.

However, when we look closer at dilution we begin to see one company’s growth separate from the other. Over the past 10 years the number of Boyd’s outstanding common shares (units) have increased at an average annual rate of 5.24%. If we deduct this share growth rate from the revenue growth rate to calculate the per-share revenue growth rate, we arrive at an average per-share revenue growth rate of 19.8%, which is still very impressive. The shares that Boyd has issued have not diluted the shares of the existing shareholders enough to dampen their returns much.

In contrast, Exchange Income Corp has issued a proportionately much larger number of shares over the past 10 years. As a result the number of common shares which are issued and outstanding have grown at an average annualized pace of 22.03%. If we deduct the growth rate of the shares from the growth rate of the revenue to get the per-share revenue growth rate, we discover that the average per-share revenue growth rate of Exchange Income Corp over the last 10 years is only 0.9% a year. If we were valuing the two companies based solely on this metric, we can see that Boyd would be the clear winner.