How Interest Rates Can Affect Stock Prices

How interest rates will affect stocks may be a question that many investors are interested in at the moment.

It took me some serious thinking before I realised there are two ways that interest rates could affect stocks. Let’s take a look .

One link between interest rates and stock prices: The cost of doing business

A business gets capital, either from equity investors or debt providers, to invest in ventures for the generation of a profit in the future. When it comes to debt, the capital is “rented” temporarily to a business. Since it has to be repaid in the future, there is a “charge” or “rental” for the capital, which is known as the interest rate.

The profit that a business can charge is given by a simple equation:
Profit = Sales – Expenses

The expenses item also contains the interest that the business has to pay to its debt providers. Thus, if the interest rate increases, a business’s profit will be reduced, keeping all things equal. A lower profit will generally ding a business’s real economic value, which is in turn, a strong determinant of a business’s stock price over the long-term. In this way, you can see how high interest rates can be bad for a business.

But, investors should note that banks can be an exception from this scenario. In Singapore’s stock market, there are really only three banks, namely, DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39), and United Overseas Bank Ltd (SGX: U11). Banks, which are debt providers, can benefit from high interest rates.

Another link between interest rates and stock prices: Valuation

Theoretically, one of the best methods to value a stock is something known as a discounted cash flow model.

Though hard to implement practically (with reasons that would take an article or more to explain), the logic of this method in evidently clear. In simple terms, a discounted cash flow model aims to calculate the value of a business by predicting all the future cash flows said business can produce and discount them back to the present at a specific rate. This model can be reduced to a simplified formula:

Value of a company = Cash inflows / Discount rate

This discount rate in turn is influenced by prevailing interest rates – a high (low) interest rate will generally result in a high (low) discount rate. So as you can see, a high interest rate can lead to a low value for a company and vice versa, thus affecting stock prices.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Lawrence Nga doesn’t own shares in any companies mentioned.