So why are stock prices going down with the fear of interest rate increases? Rates haven’t even increased yet so what’s all the fuss about? That’s a good question. Big moves like we have experienced in the last few weeks can reinforce the notion that the markets are irrational, don’t make any sense, and therefore can’t be trusted – or worse yet, should be feared. However, what is happening will make more sense to you if you understand how the markets work. You can then dispel those negative views and stay on course with your long term plan. Let’s look at a few factors that affect stock prices and consequently the overall market.
One of our principles is that educated clients are better clients. Just a little bit of technical explanation is going to be helpful for you, so bear with us. While we tend to dive deep into these learnings, we’re going to do our best to keep this concise. If you find any of this difficult to understand, do not worry. If this was easy everyone would have it figured out and they certainly do not.
In principle, the value of a company today is based on the current value of the future cash flow it pays to the people that own it. Simple enough, but a few things have to be determined.
- First, you have to determine what the future cash flows are going to be. It doesn’t matter what the stock has done in the past; all that matters is what cash flows the stock is going to generate in the future. Herein lies the biggest problem. No one knows what future profits are going to be because they are in the future. A lot of people spend a lot of time trying to predict what these future profits will be. A common practice is to assume future dividends will grow by a consistent percentage, say 3%. That means next year’s dividend is going to be 3% higher than this year’s dividend and the next year the dividend will be 3% higher still. This is why companies are so focused on consistently growing their dividend.
- Second, you have to determine the current value of the future cash flow. To determine the current value of the future cash flow, you have to discount them by the rate of return you want to earn by making the investment. This is called your required return. Here’s an example: if you expect a company to pay you a $100 dividend in one year and you want to make 5%, then the $100 would be worth $95.24 to you today. Another way to say this is if you want to earn 5% on your money to get to $100 a year from now, you’d have to invest $95.24 today. If you expect the same company to pay you $103 in two years, the present value of $103 to you would be $93.42. So on and so forth.
Adding up all these discounted future payments boils down to the following equation. (We hope we are getting brownie points for including an equation in an e-mail to you.)
For example, assume our required return is 6%. If ABC Corporation just paid a dividend of $2 per share and is expected to grow its’ dividend by 3%. We can use these inputs in the above equation to determine how much we should pay for ABC Corporation stock:
Okay, now that we have laid the ground work we can understand how rising and falling interest rates affect stock prices. What you want to earn on an investment starts with the rate of inflation or the increase in the cost of goods in the future. There is that pesky word “future” again. All inflation happens in the future so by definition it is a prediction. Most people want to earn as their required return at least the rate of inflation, if not more. So if anticipated inflation goes up, the rate of return you want or need to earn goes up too. Conversely, if inflation goes down, the rate of return that you want or need to earn goes down.
For the purposes of this example, let’s assume that interest rates are expected to increase 1%. Due to this increase in the interest rate, our required return that we used above moves from 6% to 7% to account for the increased inflation. Let’s plug this new required return into the above equation:
So there you have it. There are definitely more layers to the valuation process for a stock, but this is a basic concept that affects stock prices and illustrates how changes in the inputs to this equation moves the markets up and down.
As you can see, stock prices are built on assumptions about future profits and expected inflation (interest rates). These assumptions can change in an instant. Right now the assumption around what expected inflation is going to be is being challenged due to the improving economy. See how an improving economy can actually make stock prices go down temporarily? Now, we can also see in the above equation how increasing dividend growth rates in an improving economy can offset increasing inflation. I hope this is a little less of a mystery now.
Fortunately, for long term diversified investors, precise predictions of future growth rates and inflation rates aren’t that important. Stock prices (and the assumptions behind them) go through gyrations that create a lot of noise and fodder for the evening news but they tend to trend up over the long term. Why? Because the equation has a built in rate of return that the owner of the stock is expected to earn. Remember the “required return” in the above equation.
Okay, we’re sure you have had enough of this for now. At least enough to look smart at your next party, right? Let us know if this kind of education is helpful for you and we will try to give you more.