Valuation and the rate environment

You can explain why rising interest rates lower the value of future cash flows, why distant cash flows are hit hardest, and how this showed in 2022.

Same business, lower price

In 2022, many companies kept growing their sales. Some reported record profits. Yet their share prices fell by a third or more.

Their businesses had not suddenly become worse. What changed was the price of money. Interest rates rose faster than at any time in decades, and that alone lowers what investors will pay for future profits. Understanding why connects the valuation models of this chapter with the central bank decisions in the news.

Distant cash is hit hardest

Every valuation, explicit or not, discounts future cash. The discount rate usually starts from the risk-free rate, the yield on government bonds of a safe country, and adds a premium for the extra risk of shares.

When government bond yields rise, investors can earn more without taking company risk. They then demand more from shares too. The discount rate goes up, and every future dollar is worth less today.

The effect grows with distance:

100 dollars paid in 2 years is worth 94.3 today at 3% and 90.7 at 5%: a drop of 3.8%.
100 dollars paid in 20 years is worth 55.4 at 3% and 37.7 at 5%: a drop of 31.9%.

That is why companies valued for profits far in the future, often young technology firms, react much more strongly to rate changes than mature companies paying steady profits today. Bond investors know the same effect as duration: long-dated bonds lose more when yields rise.

In the DCF from the start of this chapter, raising the discount rate from 8% to 9% cut the value per share by about 17%, with no change in the business.

2022: rates up, prices down

In March 2022, the US Federal Reserve began raising its policy rate from near zero. By December 2022, the target range stood at 4.25% to 4.50%. The yield on 10-year US Treasury bonds rose from about 1.5% at the end of 2021 to about 3.9% at the end of 2022.

Share prices fell, and not evenly:

The S&P 500 lost 19.4% in 2022, its worst year since 2008. The Nasdaq Composite, heavy with technology and growth companies, lost 33.1%. Rates were not the only cause. High inflation and fears of a recession weighed too. But the pattern matches the arithmetic: the shares whose value rested most on distant profits fell furthest.

Common mistakes

Valuing shares without looking at rates. A P/E that looked normal at 1% bond yields can look high at 4%.
Assuming falling rates always lift prices. Rates often fall because the economy weakens, which hurts the profits themselves.
Treating all shares the same. Rate changes hit long-duration growth shares harder than mature, cash-paying businesses.
Forgetting debt. Higher rates also raise interest costs for companies that must refinance.

The takeaway

Higher interest rates raise the return investors require, so future cash is worth less today. Companies valued for distant profits are hit hardest.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the value that falls most, in percent, when rates rise from 3% to 5%.

Tap the chart.

100 paid in 20 years drops from 55.4 to 37.7 today, almost a third. 100 paid in 2 years drops by under 4%.
2Why does a higher government bond yield usually raise the discount rate for shares?

The risk-free rate is the starting point of most discount rates. Shares must offer more to be worth the extra risk.
3Which company's value is usually most sensitive to rising rates?

Distant cash flows are discounted over many years, so a higher rate cuts their value most.
4Do falling rates always lift share prices?

Lower rates raise the value of future cash, but the reason for the cut matters. A recession can lower the cash flows themselves.

of 4 correct.

Sources

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