While higher interest rates represent pennies from heaven for long-suffering income investors, they are no friend to growth stocks, and it’s incumbent on you to understand why.
By getting your head around the overarching nexus between interest rates and listed companies, you’ll be much better informed about which ones to own for the longer haul.
For starters, in an environment of lower-for-longer interest rates, all asset prices receive an uplift. It’s not brain surgery – within a low-interest-rate environment, companies simply have what’s called a lower expense ratio.
From an accounting perspective, this means less interest expense on a company’s profit and loss statement, and this can find its way to the bottom line – and potentially greater profits.
What your broker or financial adviser may struggle to explain clearly to you are the effects on company earnings that come from A) the applied discount rate on future cash flows, and B) that lower interest rates result in higher earnings multiples.
When thinking about the discount rate on future cash flows, imagine you could put your cash into a term deposit and earn 4%. (Not far off by the looks of it).
In this world, a company yielding, say 5% in earnings annually is OK, however it’s far from great given the increased risk you are taking by investing in a company.
Imagine now the term deposit rate falling to just 1%. All of a sudden, the 5% earnings yield company is much more valuable in this low-interest-rate environment.
This is why the value of companies goes up when interest rates go down.
Why is that you ask? Simple, lower interest rates tend to have a more magnified effect on stocks that are growing faster – aka growth stocks.
This means the more growth a company has, the greater the upward push on its asset prices.
As a result, investors should ideally focus on long-term, sustainable growth stories.
Companies that can grow their earnings sustainably over the long-term have the potential to significantly increase in value in today’s low interest rate environment. And even though interest rates are on the rise, they’re likely to remain relatively low – by historical measures – for some time.
Here’s a simple, yet useful example to illustrate the magnified effect lower interest rates have on growth stocks.
Imagine a stock increasing its earnings at 1% annually. In a 4% interest-rate world, its P/E ratio should be around 12x.
But in a 2% interest rate world, its P/E ratio should be around 16x.
To put it another way, this stock is worth around 33% more if interest rates were to fall from 4% to 2%.
Need further explanation of the nexus between interest rates and individual companies?
Think of it as simply the ‘opportunity’ cost of capital.
For example, $1 in your hand today is worth more than $1 in your hand in a year’s time, because you could have invested that dollar and earned a return in the meantime.
The higher the return you can earn on that dollar, the lower the value of the future dollar. And vice versa when interest rates are low, When the opportunity cost of investing is low, the higher the value of the future dollar.
It’s equally important to remember that any asset is priced on the cash flows the asset will generate, and is discounted back, courtesy of the function of interest rate levels into the future.
But if interest rates were merely low today, and back up to historical levels next year, there would be no real change in asset prices.
However, that’s no longer the case, and this is a really big deal.
What signalled a major turning point in 2018 was the slow and steady realisation by market participants that interest rates were increasingly likely to remain lower for longer.
While we’re clearly at another inflection point, the jury’s out on whether we will ever see a return to normal interest rates, and how long it might take to get there.
Meantime, what really matters is the long-run, interest-rate expectations – five to seven years and beyond – and not simply what the RBA does to rates today.
Companies most likely to benefit from lower-for-longer interest rates, will be those with higher growth projections, cleaner balance sheets – ideally with net-debt to equity below 30% – and sustainable core earnings.
But with interest rates on the rise, its growth stocks carrying a lot more debt that stand to suffer.
In short, the multiplier effect is ultimately how interest rates impact growth stocks.
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