Effect of Interest Rates on Equity Valuations
Step-function changes to interest rates lead to step-function changes in valuation.
Interest rates have been on a steady decline since 2007. After reaching a local maximum in late 2018, rates have dropped precipitously. In 2020, the Federal Reserve took unprecedented action, dropping short-term interest rates to near 0%.
The market, on the other hand, has climbed to reach new all-time highs.
While market prices are primarily influenced by company fundamentals, certain macroeconomic factors such as interest rates have direct or indirect effects a company’s performance and market price.
Expected Returns & Earnings Yield
The Capital Asset Pricing Model (CAPM) describes the relationship between risk and reward, essentially stating that higher risk commands higher returns.
The CAPM states that expected returns are a function of the risk-free rate and risk.
The model uses beta, or the volatility in price as compared to a benchmark, as the benchmark for risk. The risk-free rate is determined from a safe, conservative alternative investment option, often treasury bonds. Because of their inherent risk, equities command an additional return, or risk premium, over the risk-free rate.
Rather than diving into the details of the formula, this article presents an intuitive approach to understanding the relationship between rates and valuations.
Consider the simplified formula: expected return = risk-free rate + equity risk premium.
Assuming a risk-free rate of 2% and an expected market return of 6%, subtract the risk-free rate from the expected return to determine the equity risk premium.
In other words, investing in equities should return the 2% risk-free rate plus 4% equity risk premium for a total expected return of 6%.
Risk-free rate: 2%
Equity risk premium: 4%
Total expected return: 6%
Earnings yield, the inverse of the P/E ratio, is an alternative view of expected return.
The earnings yield required is 6%. This implies a P/E ratio of 16.67.
Impact of Change in Risk-free Rates
Consider a change in the risk-free rate from 2% to 0%. How does this affect price?
The equity risk premium remains unchanged at 4%. Adding the 0% risk-free rate, the total expected return is 4%.
Risk-free rate: 0%
Equity risk premium: 4%
Total expected return: 4%
The earnings yield required is 4%. This implies a P/E ratio of 25.
As the risk-free rate drops, so does the required earnings yield, making equities more attractively priced. The P/E multiple rises in order to reflect the future expected returns. Because of the lower interest rates, investors are willing to pay more today for lower returns in the future.
Conclusion
Setting interest rates is one of the Federal Reserve’s tools for promoting the stability of the financial system. Lower interest rates stimulate the economy, making it more attractive to spend today. Lower interest rates may lower the costs for undertaking a new project, where a lower discount rate may make it more likely to clear the company’s return hurdle. The ultimate effect of lower rates on equities is in an increase in valuation.
Step-function changes to interest rates lead to step-function changes in valuation.
The economy has benefitted from decreasing rates for many years. The benchmark for short-term rates is now near 0%. Although it may be a few years, it is more likely than not that rates will increase in the future.
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Federico Torre
Torre Financial
federico@torrefinancial.com
https://torrefinancial.com
https://torrefinancial.substack.com
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Disclaimer: This post and the information presented are intended for informational purposes only. The views expressed herein are the author’s alone and do not constitute an offer to sell, or a recommendation to purchase, or a solicitation of an offer to buy, any security, nor a recommendation for any investment product or service. While certain information contained herein has been obtained from sources believed to be reliable, neither the author nor any of his employers or their affiliates have independently verified this information, and its accuracy and completeness cannot be guaranteed. Accordingly, no representation or warranty, express or implied, is made as to, and no reliance should be placed on, the fairness, accuracy, timeliness or completeness of this information. The author and all employers and their affiliated persons assume no liability for this information and no obligation to update the information or analysis contained herein in the future.