Jargon buster: how interest rates affect valuations

In this jargon buster we look at the role interest rates play in helping to determine the value a company.

How interest rates affect valuations

The prospect of rising interest rates has implications for the valuations of companies.

Higher interest rates reduce the relative appeal of companies paying a big dividend. All of a sudden, the interest on offer at the bank from a bond is more attractive – as more viable alternatives are now available.

However, rising interest rates can also hurt the so-called ‘growth’ stocks. A growth stock is one that has a long growth pathway ahead of it – such as a technology or healthcare company.

The profitability of such a company is not expected to reach its potential until much later down the track.

Firstly, it’s worthwhile going over how the value of any company (or anything that generates cash) is theoretically derived. Investors ‘discount’ those future cash flows using a notional rate of return, or ‘discount rate’. This is done because the same amount of money is more valuable in the present, than in the future (due to inflation and the opportunity cost of putting that money to work elsewhere). The discount rate varies from company to company but is heavily influenced by the current ‘risk free’ rate – usually that of a government bond.

In this formula, r represents the discount rate and n the number of years into the future the cash flow occurs.

The theoretical value of a company is simply the summation of all of these individual future cash flows. So far so good.

Interest rates affect valuations differently

A change in the interest rate has a disproportionate impact on the present value of cash flows further into the future, as compared to those in the not too distant future. It is basically compounding interest in action (but in reverse).

To demonstrate, consider two companies – Company A and Company B. Company A is a mature company that grows its cash flows at a reasonably meagre 2% each year (over the next 30 years in this example). Its starting cash flow is $1,850. Company B on the other hand, has much smaller initial cash flows ($250) but is growing its cash flows at 15% annually. At a discount rate of 5%, both companies have very similar valuations.

However, as the table above illustrates, a three-percentage point increase in the discount rate, from 5% to 8%, has quite different impacts on the present value of both companies.

It sees the low growth Company A’s valuation drop by 29.4%, while the higher growth Company B’s valuation drops by 44.3%. In a higher interest rate world, Company A is now worth more than Company B.

We should also point out that – as is the case with all modelling and forecasting – trying to pinpoint the value of a company using a discounted cash flow model is as much an art as a science. With such a vast array of inputs that an analyst would have to estimate (including that of the appropriate discount rate to apply) the process is fraught with opportunities to be proven wrong.

The process is extremely useful, particularly as a tool for scenario analysis, but investors would be wise to view it as one of many factors to consider when evaluating a company, rather than the key one. As the British statistician George Box famously said in the 1970s, “all models are wrong, but some are useful”.

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