How Interest Rates Change Stock Valuations

A share is a claim on future profits. The value of those profits today depends on how far in the future they arrive and on the interest rate used to bring them back to the present. That second factor is the hinge between the central bank and the share market, and it explains why index traders watch rate expectations as closely as currency traders do.

The discounting mechanism

Money in the future is worth less than money today, and how much less depends on the interest rate. When rates rise, future profits are worth less in present terms, and share prices fall unless profits are expected to rise enough to compensate. When rates fall, the reverse.

Growth versus value

A mature company earns most of its value from profits in the next few years. A growth company earns most of its value from profits expected a decade away. A change in rates affects distant profits much more than near ones, so growth companies are more sensitive to rates than mature ones. This is why the technology-heavy index swings more on rate news than the blue chip index, and why rotation between growth and value often follows a shift in rate expectations.

Rates and earnings

Rates also affect profits themselves. Higher rates raise borrowing costs for companies and for their customers, slow the economy and reduce earnings. Lower rates do the opposite. So a rate rise hits shares twice: through the discount rate and through the earnings outlook. The second effect arrives with a lag of quarters, which is why an index can hold up for a while after rates rise and then fall when the earnings effect appears.

The index does not react to the current rate as much as to the expected path. A rate rise that was priced does little. A change in the expected number of future moves does a great deal.

Practical implications

• On days with rate news, expect the technology index to move more than the blue chip index
• A rising rate path argues for smaller size in growth-heavy indices and more patience with dips
• A falling rate path supports growth indices first and the broad market later, once earnings respond
• Watch the earnings reaction with a lag; the rate effect is immediate, the profit effect is slow

What to watch

Watch the expected rate path, the gap in performance between growth and value indices, and the earnings guidance that follows a change in rates. When rate expectations and earnings expectations move in the same direction, the index move tends to be large and durable.