Recs

2

Rising Prices Don't Mean Inflation

At the mightybargainhunter.com blog the other day, I read an interesting point: "Inflation and rising prices are often used interchangeably, but they're not the same thing." The author explained that technically, inflation is an increase in the money supply (which dilutes its value), while rising prices are a possible (but not inevitable) consequence of inflation, "because people have more dollars (say) in their hands with which to bid up the price of anything that the money can buy."

The article went on to explain, "Prices rise and fall for other reasons besides inflation." For example, look at the inflation rates for the past few years:

Year

Inflation rate

2003

2.27%

2004

2.68%

2005

3.39%

2006

3.24%

2007

2.85%

Not so shabby for 2007, right? The inflation rate was lower than it had been in several years. Yet gasoline prices rose around 9% during 2007. And the prices of items such as computers and televisions have been falling for years. A glance at eBay also reveals the frequent disconnect between prices and inflation. Items that are scarce command higher prices -- regardless of inflation. (Note that inflation in other countries varies widely, from 0.5% in 2007 for Israel to more than 10,000% for Zimbabwe in the same year.)

What to do
There are some parallels to investing here. Inflation happens when a government increases the money supply, thus diluting the value of the currency. Similarly, stocks can become diluted when a company issues more shares (for example, to award to employees). Fellow Fool Dan Caplinger explains how this can hammer your stock, citing examples such as Chesapeake Energy (NYSE: CHK  ) and Citigroup (NYSE: C  ) .

You can get a handle on a stock's dilution by flipping to its income statement and seeing whether the diluted share count is rising rapidly. A glance at Advanced Micro Devices' (NYSE: AMD  ) income statement, for example, shows it rising 50% between 2004 and 2007. That level of dilution quickly makes existing shares worth much less. Crocs (Nasdaq: CROX  ) has seen its diluted share count jump 71%. Overstock.com (Nasdaq: OSTK  ) ? 33%. Sun Microsystems (Nasdaq: JAVA  ) ? 10%. Microsoft (Nasdaq: MSFT  ) ? It's bought back 9% of its shares over that time frame.

On the other hand, the price increases can be seen as evidence of people's desire to own stocks. Right now, stocks are falling -- partially because the businesses are suffering, but partially because many people don't want to own stocks. That creates an extreme buying opportunity for you and me.

If you don't want to spend time studying stocks, consider managed mutual funds, where professional managers keep an eye on dilution for you. I invite you to give our Motley Fool Champion Funds newsletter a whirl. A free trial includes full access to all past issues, so you can read about each recommendation in detail.

Longtime Fool contributor Selena Maranjian owns shares of Microsoft. Crocs is a Motley Fool Hidden Gems Pay Dirt selection. Microsoft and Chesapeake Energy are Motley Fool Inside Value recommendations. Try our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.


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Selena Maranjian
TMFSelena

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter...

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