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Interest rates and why they matter even for Equity Markets

Over the last year or two, there has been a lot of talk on media channels on interest rates and what they mean for the markets.

And sometimes it is not clear why this should be so.

After all interest rates define the return you get on fixed deposit, bonds and other fixed income instruments. As interest rates go up the returns on these instruments also increase. Of course the price of a bond yielding a fixed coupon will go down as the interest rates in that economy or currency go up. This much appears straightforward.

For example, suppose a government bond pays 4% per annum. That means it pays an annual coupon of Rupees 4 on a face value of Rs 100. For ease of calculation, we are assuming for simplicity sake that this is a perpetual bond that will just keep paying interest.

Now if interest rates go up from 4% to 6% the bond price will need to come down buy one third, from Rs.100 to Rs.66.6, because 4/66.6 = 6%.

This much is intuitively clear to anyone with a school level knowledge of arithmetic.

What is not so intuitively clear is why should this impact shares or equity markets.

Let me try to simplify it a bit. I will be doing a separate blog series on what determinants of the P/E ratio ie the Price-Earnings ratio but at the simplest level it is calculated as the Earnings per share divided by the Stock Price. Which is also the same as Net Income divided by Market Capitalisation.

Let's look at what it really means. 

Now let's play around. What if we invert the P/E where the numerator becomes the denominator and the denominator becomes the numerator.

What does P/E inverted become? It becomes E/P, which is known as earnings yield.

E means earnings or profits, divided by price.

It is trying to capture what you're earning or the rate of return in a crude sense when you invest in the equity markets.

Think of it this way: if you are running a small business where you invest 5 lakh rupees and earn a profit of 75,000 rupees in a year your e by p or earnings yield becomes 75,000 divided by 5 lakhs which is 15%. 

But you could have invested in some debt also and earned, maybe 10%. The higher risk you are taking by starting a business is being compensated by the higher yield which is 15% instead of 10% on debt.

Therefore the acceptable, or expected, return from an equity investment in a business is some percentage over and above the return you can make from lower risk debt, so interest rates are implicit in the calculation of what is an acceptable or desirable PE.

Hence, as interest rates go up, you want to earn more from equity. Plus you want to earn more than what you would get from a fixed deposit if you come to the equity markets.

So if the interest rate on bonds or fixed deposits goes up to 15% you will want to earn more from equity, otherwise you would not want to take the higher risk.

That is why when the interest rates go up, the acceptable or expected returns from equity also goes up.

In equity markets this mean that the E/P that you want, goes up which means the P/E goes down.

Therefore as interest rates go up, the market P/E goes down.

But this effect is not the same for every company.

The reason for that is, if you look at it another way, earnings accounting profits are only an approximation. Ultimately the value of the company is the discounted value of all future cash flows of the company.

When interest rates are low the future cash flows don't lose much value in being discounted back to today.

For example, around 2020 interest rates in most Western Nations were around zero - some were even negative.

When interest rates are Zero, then you don't care whether you earn 100 Dollars today or 100 Dollars five years later. Because that five years out 100 Dollars has the same value.

However, if interest rates go up, that five years out 100 Dollars cash or profit is no longer as valuable.

Hence, when interest rates goes up what happens is...that the effects is more on on so-called Growth Companies -which means compamies which have very low profits  or cashflows today but they have a lot of promise, that they will make much more profits or cashflows in the future.

Think of so called new age companies like Uber and Doordash or Peleton in the US or companies like Zomato, Paytm and Policybazaar in India, which were not profitable when they came out with their IPOs, but are supposed to become profitable in the future - maybe 5 or 10 years later.
In this cases all that you are buying is the promise of future cash flows as no cash flows existed as of the public issue date.

Now, if in the inteim, interest rates go up, those years out of profits and cashflows are valued less and less.

And therefore, as  interest rates go up the value of these companies falls much more than companies which have profits and cashflows today itself.

That is why it is said that value does better than growth when interest rates go up. Because value is supposed to capture companies which have more profits, book value and cash flows today as compared to those who have only the promise of these in the future.

That, my friends, is the story in short of interest rates and equity markets.

From the desk of
Devina Mehra 
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