Over the years we have written several times about the impact of interest rates on stock prices. While we have mentioned the mathematical effects increasing interest rates have on stocks, we have never done a deep dive on this mechanism or explained some of the more tangential issues associated with rising rates. So, without further ado, here is a deep dive on interest rates and stock prices.

Interest Rate Changes Can Have Huge Effects on Prices

To show how large an effect interest rates can have on prices, I wanted to use mortgages as an example. As everyone knows, higher interest rates mean higher mortgage payments. They also mean more interest will be paid over the life of the loan- increasing the total cost of the home when you include the financing charges. The table below shows the payment, total interest, and total cost of a 30-year, $500,000 mortgage.

As you can see, even small increases in interest rates have huge effects on the total cost of a mortgage. An increase in rates from 2% to 3% raises to total cost of the mortgage by over $93,000 over the life of the loan. This is an increase in total cost of 14% from just a 1 percentage point rise in rates! An increase in rates from 2% to 8% nearly doubles the total cost of the loan.

A corollary to this concept is one that is also familiar to homeowners- How much house can I afford based on the amount I want to pay each month?

As you can see in the table above, interest rates have a huge effect on housing affordability as well. At a monthly payment of $1848, the size of the loan you can take is nearly cut in half from a 2% interest rate to an 8% rate.

The Math Behind Stock Prices

The most basic way to think about what a stock is worth today is to determine how much money the company will make in the future. Since corporations are expected to exist forever, “the future” is a very long time. But who in their right mind would pay a price today that equals all of a company’s future earnings? As John Maynard Keynes once said “In the long run, we are all dead.” So, it stands to reason we should receive some sort of discount on the value of those future earnings.

This concept- that a dollar in the future is worth less than a dollar today- is known as the “time value of money” and it is a crucial underpinning of finance. The time value of money concept seeks to apply a discount rate to cash flows in the future to come up with an appropriate value today- known as the “present value.”

Let’s look at a very simple example of a stock that is expected to deliver $100 in dividends to be paid out at the end of each of the next 10 years (in this example the company dissolves after 10 years). Let’s also assume that the appropriate discount rate is 2%. What should an investor pay today for that future cash flow?

The correct amount to pay today would be $898 for the future stream of $1000 in income.

From experience, most of us know that when interest rates move, not all stocks are affected equally. Stocks that fall into the growth category- companies that are either growing profits quickly or those who aren’t expected to turn a profit for many years- are affected much more than the more stable “value” stocks. The previous table clearly indicates why this is the case- the further out in the future the cash flow will occur, the lower the present value. If a company is expected to grow quickly, by definition the largest cash flows will occur further in the future.

Now let’s take a look at the same company as the previous example but with different discount rates.

Clearly, interest rates have a major impact on the present value of the stock. In this example, an increase in the discount rate of 1 percentage point from 2% to 3% decreases the value of the stock by 5%. If rates doubled from 2% to 4%, the value of the stock would fall by 9.7%.

How Else do Interest Rates Affect the Value of Companies?

Companies that are carrying a lot of debt can be severely impacted by rising interest rates. Often, companies will roll their debt forward by issuing new bonds as older bonds mature. This is a very prudent strategy, especially when interest rates are low. However, when rates are rising, this means that lower yield bonds are being replaced with higher yield bonds which increases the company’s interest expense and decreases earnings. Certain companies also have floating rate debt which is similar to an adjustable-rate mortgage- when the benchmark rate rises, so does the interest rate on the loan.

Higher interest rates also make long-term projects less attractive. The reasons for this are two-fold: 1) Higher interest rates mean the costs of financing projects are higher (more interest) and 2) higher discount rates mean the present value of undertaking such projects is lower. When companies don’t pursue long-term projects (or research and development for that matter), it can lead to lower earnings down the road.

Higher rates can also negatively affect a company’s sales. Think about automotive manufacturers or realtors- the cost of money for their customers directly influences both the volume of sales and the prices that customers are willing to pay. Again, lower sales mean lower earnings.

Interest rates underpin virtually everything in finance. This is why we pay so much attention to interest rate policy from the Fed. Changes in rates have both immediate and long-term consequences for businesses and the stock market. The diffuse effects of interest rate policy also show why interest rate increases are so effective at tamping down inflation. Increased interest rates apply downward pressure to stock and bond prices as well as anything that is financed; higher rates discourage investment by businesses and remove some of the demand for things like cars, houses, and boats. Therefore, even relatively small changes in rates can have profound impacts on financial assets and the overall economy.