What Investors Should Know About Interest Rates

If you're ever looking for a topic to help wrap up a conversation quickly so that you can be left alone to think about your investments, then start talking about interest rates. Your listener's eyes are guaranteed to glaze over and you'll be alone in no time.

But for those who own investments, the topic is not as dry as you think. In fact, it is something investors should make an effort to understand. According to financial theory, interest rates are fundamental to company valuation, and therefore play an important role in how we put a price on stocks.

Here we take a look at the relationship between interest rates and stock price. 

Think of an interest rate as the cost of money, which just like the cost of production, labor, and other expenses is a factor of a company's profitability.

The fundamental cost of money to an investor is the Treasury note rate, whose return is guaranteed by the "full faith and credit" of the U.S. government. According to financial theory, a stock's value proposition starts there: stocks are risky assets, even riskier than bonds because bondholders are paid their capital before stockholders in the event of bankruptcy. Therefore, investors require a higher return for taking on extra risk by investing in stocks instead of Treasury notes, which are guaranteed to pay a certain return.

The extra return that investors can theoretically expect from stocks is referred to as the "risk premium." Historically, the risk premium runs at around five percent. This means that if the risk-free rate (the Treasury note rate) is four percent, then investors would demand a return of nine percent from a stock. Therefore, the total return on a stock is the sum of two parts: the risk-free rate and the risk premium.

If you want higher returns, you must invest in riskier stocks because they offer a higher risk premium than, say, stronger blue chip companies. In theory, rational investors will select an investment with a return that is high enough to compensate for the lost opportunity of earning interest from the guaranteed Treasury note and for taking on additional risk.

(To learn more, see The Equity-Risk Premium: More Risk for Higher Returns.)

If the required return rises, the stock price will fall, and vice versa. This makes sense: if nothing else changes, the price needs to be lower for the investor to have the required return. There is an inverse relationship between required return and the stock price investors assign to a stock.

The required return might rise if the risk premium or the risk-free rate increases. For instance, the risk premium might go up for a company if one of its top managers resigns or if the company suddenly decides to lower its dividend payments. And the risk-free rate will increase if interest rates rise.

So, changes in interest rates impact the theoretical value of companies and their shares — basically, a share's fair value is its projected future cash flows discounted to the present using the investor's required rate of return. If interest rates fall and everything else is held constant, share value should rise. That's why the market generally cheers when the U.S. Federal Reserve announces a rate cut. Conversely, if the Fed raises rates (holding everything else constant), then share values are likely to fall.

Interest rates impact a company's operations too. Any increase in the interest rates that it pays will raise its cost of capital. Therefore, a company has to work harder to generate higher returns in a high-interest environment. Otherwise, the bloated interest expense will eat away at its profits. Lower profits, lower cash inflows and a higher required rate of return for investors all translate into depressed fair value for the company's stock.

Additionally, if interest rate costs shoot up to such a level that the company has problems paying off its debt, then its survival may be threatened. In that case, investors will demand an even higher risk premium. As a result, the fair value will fall even further. 

Finally, high interest rates normally go hand-in-hand with a sluggish economy. They prevent people from buying things and companies from investing in growth opportunities. As a result, sales and profits drop, as do share prices.

In financial theory, valuation begins with a simple question: if you put money into this company, what are the chances you will get a better return than if you invest in something else? Interest rates play an important part in determining what that something else might be.

(For more, check out How Interest Rates Affect the Stock Market.)