Educational Spotlight – Why do interest rates matter for stock prices?

When stock price multiples got to extreme high levels, many justified them based on interest rates. Likewise, the stock market decline is blamed on rising interest rates, among other things.

Investments are priced based on risk. Theoretically, government bonds, held to maturity, have no risk – the government can always print the money to pay off the bond. This makes them the “risk-free asset” off of which everything else is priced. Investment grade corporate bonds need to offer a little higher yield to compensate for the risk of downgrade or default. High yield, or junk bonds, need a higher yield still. Stocks represent the ownership of the residual cash flows of a company. Bond holders get paid first, and shareholders get whatever is left over. For this reason, stocks should be priced to earn a higher return than bonds to compensate for the higher risk. The price/earnings ratio is a common way to value stocks, but really this is a shorthand method. The value of any stock is the value of all future cash flows, discounted to today at whatever the discount rate is. For a riskier stock that rate will be higher. For instance, let’s assume a risky stock is expected to earn $1.00 next year and to grow earnings at 30%. Assuming a 10% discount rate, the $1 in a year is worth $1.00/(1+10%) = $.91. The following year’s earnings is worth 1*(1+30%)/(1+10%)*(1+10%) = $1.07. The sum of all future cash flows should equal the current price. Note that I am using earnings as a shortcut, but it is actually cash to the investor that matters. Mathematically, the stocks valuation multiple falling is the same thing as the discount rate rising. (See https://rothmaninvest.com/resources/estimating-future-returns for the other side of this math.)

As government interest rates fell from the early 1980’s until 2021, the expected yields of everything else fell with them. Price moves inversely to yield – a higher price today for the same cash flows in the future pushes the yield lower. Not only did the expected yield of everything fall along with the risk-free rate, but the price of risk (risk premium) also fell, as investors were pushed to take on more risk to try to achieve the returns they need. This “double whammy” pushed the price of risky assets much higher, enriching investors – at least on paper. At some point, the price momentum took on a life of its own, drawing in new investors speculators who wanted to get in on the easy money.

Here is an example. If the ten-year treasury yield is 1%[1], and the equity risk premium (the return expected by investors for accepting stock market risk) is 2.5%, stocks should be priced to earn 3.5%. This equates to a price about 30 times one year of earnings. If the treasury yield rises to 4% and the equity risk premium rises to 5%, investors will demand a 9% expected return, which means stocks will trade at about 11x earnings. If a recession causes just a 10% decline in corporate earnings, stocks would lose over two-thirds of their value in this example.

One final note – rising (falling) interest rates hurt (help) growth stocks more than value stocks because growth stocks have cash flows further out in the future. In the bond world, this is called duration – the average time outstanding for future cash flows. Just as longer dated bonds lose more value on rising rates, so longer-horizon companies stand to lose more value as investors discount those far off cash flows at a higher rate.

[1] The ten-year treasury yield got down to 0.62% on 7/1/2020, and was between 1% and 2% for most of 2021. As of 10/28/22 it is 4.02%. See https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2022