Why Rising Interest Rates Push Down Stock Prices
Rising interest rates usually mean that stock prices are headed lower. Companies must pay more to borrow money and service their debt. Demand may fall for their products and services because customers have to pay more to borrow money leaving them with less money to spend. In this scenario the earnings and free cash flows of companies could fall putting downward prssure of their stock prices.
Another factor to consider is the intrinsic value of a stock which professional analysts use to value a stock. Formulas that compute intrinsic values can be quite complex but the one I am using is very simple and it shows how rising rates affect the intrinsic value of a stock.
This formula discounts a stream future stream of cash flows to the present. It tells you how much you need to invest now (present value) to get a specific amount of cash in the future. For a stock the present value represents the intrinsic value of the stock for a particular annual dividend and discount rate.
The formula is:
Present Value = Future Cash Flow / Discount Rate
It assumes that you will receive the same amount of cash once each year for an indefinate number of years. It also assumes the discount rate remains fixed year after year.
The follwoing table shows the affect of rising discount rates for a given fixed cash flow of one dollar per year.
|Discount Rate & Present Value|
You can see as the discount rate increases the present value falls. For higher discount rates you need a relatively smaller pile of cash to generate the one dollar dividend.
All present value models (simple and complex) include the discount rate in their denominator so as the rate increases the present value falls. It's just the way the arithmetic works.
In the real world of rising rates, when the new present value of a stock is below its current market price, expect the stock's price to adjust to the downside. For example, why would you pay $90 for a stock that gave you a $1 dividend with a discount rate of 1.25%, when the present value given that dividend and discount rate is $80.