Interest rates are rising around the world. The Bank of England increased interest rates in December 2021 from 0.1% to 0.25% while countries such as Japan, New Zealand, and Brazil have all raised their respective interest rates too.
The Federal Reserve, the central bank of the United States, also seems wary of inflation and is likely contemplating raising rates this year.
How do these actions of central banks around the world impact stocks?
Interest rates can theoretically impact stock prices in a few ways. First, it can impact the profits of a business. Companies with debt will experience an increase in borrowing costs which leads to lower profits and cash flows, all else equal.
Higher interest rates can also theoretically affect stock valuations as fixed-income yields become more attractive. This means stocks require a higher rate of return – and thus a lower valuation – to compete with the now higher-yielding instruments.
Higher rates impact high growth companies disproportionately
Higher interest rates, in theory, also impact high growth companies more than low-growth companies.
This occurs because most of the current value of high growth companies is derived from cash flows generated much later in the future. Take Tesla (NASDAQ: TSLA) for example.
Tesla is a high growth company whose cash flows it will generate many years in the future make up the bulk of the company’s value.
Using the last full-year results (FY2020), I modelled* the company with the following parameters: Revenue growth of 50% for 10 years; achieve an 18% free cash flow margin in the 10th year; share dilution of 5% a year; and a terminal growth rate of 6%.
If I need a 12% required rate of return, the net present value (discounted value of all future cash flows) per share works out to US$1,362. But if I need a 15% rate of return, the net present value per share drops to just $739. Just a 3% increase in the required rate of return reduces the company’s net present value per share by 46%.
On the other hand, let’s assume a company that starts off at a similar size as Tesla now but has much lower growth rates of just 10% and a terminal growth rate of 2%.
Using a 12% required rate of return, the net present value per share is $49. If I increase the required rate of return to 15%, the net present value per share drops 24% to $37. The key difference between Tesla and the slow growth company is that the slow growth company’s share price drops much less when the required rate of return rises.
High growth stocks have been hammered
As you can see, the higher required rate of return impacts high growth stocks disproportionately. This is possibly one of the reasons why we are seeing high growth companies whose values are largely derived from future cash flow fall more sharply than companies that have slower growth rates.
Personally, I have a large chunk of my wealth invested in high growth companies whose share prices have taken a drubbing. While it is not pleasant to see, there are two reasons why I am still optimistic.
First, based on my projected future cash flows for these companies and factoring in the fall in share prices, many of the companies I have a vested interest in look likely to provide very high rates of returns even if interest rates do keep on rising.
Second, interest rates tend to impact valuations only temporarily.
The Fed and the world’s other central banks make rate hikes and cuts based on the economic conditions at that time. Most of the time, interest rate hikes or cuts along with other monetary and fiscal measures are effective enough that the central banks will have to reverse the rate change after several years and on and on the cycle goes. As such, I believe that rate hikes and rate cuts are merely short term noise that should not impact the way we invest.
What to do now?
Personally, instead of fretting over rising rates, I focus my efforts on finding excellent companies that I believe have durable long-term growth potential.
Besides looking for growth, I also know that interest rates can impact the cost of borrowing for companies. As such, I tend to prefer to invest in companies that have relatively low debt or debt that they can easily service even if rates go up.
By focusing on these characteristics of a business, I believe my portfolio will still be well-positioned in any interest rate environment.
*You can find the calculation in this Google Sheet
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
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Disclosure: Jeremy Chia owns shares of Tesla.