### Interest Rates vs Valuations

*(This post is perhaps a year late in coming. If this had been written before the market corrections had happened, and an attentive reader would have changed their investment strategy by reading it, could have perhaps saved the said investor a few quid and likely would have bought be a beer or a cup of chai. Sadly I write this post after the blog and have probably foregone a well earn round of beverage. Nevertheless I hope to provide a framework that can be used by readers in navigating changing economic situation in the future.)*

There is so much talk about interest rates affecting stock market valuations and as the market corrected consequent to interest rates going up, a colleague of mine asked me how does a change in interest rate affect stock market valuations. As part of that conversation I tried my best to explain the fundamental effects of interest rates on Discounted Cash Flow (DCF) valuations. However, I made a mental note to follow up with a blog post where I can explain this with some illustrations. This post is that follow up and intends to be read by anyone curious about the mathematic machinations that connect interest rates and stock market valuations. This post will need basic understanding of maths (such as compounding and discounting), but nothing more than what you might have learned at high school (or perhaps sooner).

If you are an experienced investor, it is time for you to give this post a pass. But if you are investor who have never wandered into the realm of the mathematics of company valuations, the next few minutes might prove a reasonable use of your time.

As we know that a dollar or pound today is more valuable than the same dollar or pound in the future. Hence cashflow that a company is expected to be generated in the future needs to be discounted to today. You do it by discounting it at Risk Free Rate (RFR) - return that you could generate if you took no risk at all. At its core, DCF uses the expected future cash flows of a company and discounts them to today and you get valuation of a company. So when the interest rates change, then RFR changes and this impacts DCF calculations of every company out there.

* Note 1:* Please note that DCF has many inputs, all of which are subjective and hence 2 analysts may value the same company differently. However, if interest rates change, both analysts will have to change that particular input to their analysis. This post specifically looks at how that one input. i.e. interest rates affect valuations. This post is not a tutorial in DCF - there are ample tutorials online that do a great job of teaching DCF to beginners.

** Note 2:** Markets seldom trade a stock at what might be your estimation of the DCF. Market trades at the collective expectations, and behaviours of all investors and traders out there, and hence a stock might trade wildly different than what you think the company is valued at. However, the trends in price at which a stock will generally match the trend in your calculation of DCF, i.e. if your own DCF calculation of a company goes down after an interest rate change, it is very likely the stock is also down and vice versa.

In this post I present an example company, primarily for purposes of illustration of DCF maths. In this company's case, the company has revenues that grow with time, and it has margins that improve with time. The company produces a profit every year and we are interested in calculating how much should the company be valued today. Terminal Value is the value of the company when it stops growing - all companies tend to either grow or shrink or stay in size with respect to market in different phases of their life. Obviously investors need to take into account what phase the company is in and apply the right kind of calculations to value the company. In this illustration, the company I have conceived has an extremely rosy projection of growing for 5 years and then fall in line with broad economy growth.

In this classic DCF valuation scenario, I have taken 5 years of growth and then the 6th year is used for Terminal Value (TV) calculation. There are multiple ways of calculating TV - I use the method of calculating TV as Profits (of the TV year) / (Equity Risk Premium + Risk Free Return). This is equivalent to multiplying the profits with market's average P/E. As I said there are multiple ways to calculate TV and we can split hairs over whether this is the right approach or not, but this approach is not unreasonable and I use it consistently in this blog post. So, the effects of changes in the valuations that I hope to illustrate won't be affected by the formula, but only what goes into it.

So, back to our sample company illustration:

As you can see, this company is being currently valued at $521,117, a P/E of 34.74 and P/S of 5.21. So far so good. The actual numbers itself aren't very important. This obviously is a made up company with extremely optimistic outcomes. What we are interested in seeing what happens if some of these assumptions change.

### Why have growth companies decreased in valuations by so much more (80-90%) than the scenarios presented here?

- Focus on valuations - buy companies whose projection don't need ideal conditions. On that, apply a margin of safety for changing circumstances.
- If you feel compelled to buy companies at exorbitant valuations, buy small lots and see how the story pans out. You can always add to your positions.
- If you already hold stocks that have dropped significantly (80 or 90%), but where you expect the story to be intact more or less, consider continued purchase of these shares at lower prices so that you can lower your average cost of ownership over many years. If the company in fact turns out to be a super compounder over many years, your investment will still pay off very good returns. If you started with small lot purchases of these companies and have powder dry, now is the time to add to your position, but only to those companies whose growth story is intact.

**Appendix**

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