A Look at Interest Rates and Equity Market Valuation

Over the last couple of weeks, the topic of interest rates has been on everyone’s mind even more so as it relates to equity valuations, i.e., the stock market. We have been concerned about equity valuations for years especially when comparing market prices to fundamental value. Below we take look at how the recent spike in interest rate levels, and a persistence in these rate levels, will put downward pressure on fundamental equity values and corporate operating cash flows and how this may lead to deteriorating corporate financial health.

Financial Markets- Fundamental Value Impact
Merriam-Webster defines the word fundamental as “serving as a basis supporting existence or determining essential structure or function” and the word value as “relative worth, utility, or importance.” Prevailing prices for any good, service or financial instrument have basic tenets comprising its value. While some of these tenets are more evident than others, let us keep in mind what something is worth, i.e., its value, and what you pay for it, i.e., its price, are two different metrics. The value of an asset comprises cost plus its relative worth or utility to the buyer. This intangible part of value is why goods can be described as expensive or cheap as prices move upward and well above the cost to produce or downward and closer to the cost to produce.

For example, and to grossly oversimplify, it is somewhat easy to understand what makes up the cost of a house. There are materials required to build a house such as lumber, nails, concrete, paint, and land and then labor costs to assemble those materials into a finished house. If you sum the totals of all the tangible materials and labor costs this would be the total cost of the house. However, this is before assigning costs to the other intangible contributors such as geographic location, housing demand, and prevailing mortgage rates. This points to why houses of similar size, age, and material quality will be priced at vastly different levels based on location, e.g., country vs. suburbs vs. metropolitan city.

As such, when looking at financial instrument prices like one share of stock, or the collective prices of different shares, such as an index, there are inputs, albeit mostly intangible, used to assign a value to those shares. In capital market finance, at the most basic level, values are made up of a collection of observable inputs (cash flow, earnings, interest rates, revenue) to generate an output value, i.e., a fundamental value. There are several models (Valuation Models), or equations, used by market participants utilizing earnings, free cash flow, dividends, and many other metrics to derive fundamental values.

Regardless of the model used, a large component of fundamental values derived, whether directly or indirectly, is the prevailing level of interest rates. This rests squarely on the shoulders of a concept called Present Value. To spare a deep dive into Finance 101, we can simply point to the relationship of an increase in interest rates will decrease fundamental values and a decrease in interest rates will increase fundamental values. So, holding everything else constant such as earnings, cash flows, dividends and cash flow growth rates, an increase in interest rates should theoretically bring the value of a share of stock down today.

Now, our view is not that the current increase in interest rates will lead to an immediate downward repricing of equity markets. We are simply highlighting potential pressures as market participants evaluate value vs. prevailing price. Most institutional investors evaluate the prospects of a given company or sector by assigning their own forecasts in extrapolating financial results into the future. After determining a future value, it is then discounted back to today’s value. If the resulting value is lower than the prevailing price, then the stock, if held, is sold. However, if the value is above the current price, then the stock is normally purchased as there is perceived upside to the current price. Again, this process is applied to both individual companies and indices in determining fair value.

Overall, the key concern is the persistence in the current level of rates. If these levels are sustained for a longer period of time, then market participants will start to focus on the tradeoff between owning stocks and other investments such as bonds, real estate, commodities and so on. This is evident in the recent selloff in the Information Technology sector as many investors examined the low yielding, highly valued state of these companies and rotated into other opportunities offering a better return profile.

Corporate Health- Operating Cash Flow and Leverage
Profitability- Income Statement
As it relates to corporate financial health, if higher rates are due to higher inflation expectations, and those inflation levels are subsequently realized, then it becomes a headwind for corporate profits. Inflation erodes profitability as operating expenses move higher and companies are not able to pass-through the full impact of the rising prices. Further, as demand increases for goods and services the supply side can experience constraints in production due to a limited availability of inputs and labor, i.e., demand pull inflation. As these operating costs increase, it leads to now smaller net operating cash flows discounted at a higher rate and ultimately lower per share fundamental value outputs in the models referenced above.

Fortunately, while most are pointing to expected inflation as the catalyst, many have alluded to an increase in real yields driving the recent runup in yields. In general, savings levels have increased and the desire for credit remains robust leading to higher rate levels to entice continued investment. Further, prior to the pandemic, we were at full employment and on the heels of the longest business cycle expansion in U.S. history and inflation still remained below trend and somewhat subdued. Therefore, with close to 10 million still unemployed (6 million plus those dropping out of the work force temporarily) and GDP growth currently hindered by pandemic related lockdowns and restrictions, it is not likely a major uptick in inflation is on the horizon any time soon. Several economists have pointed to 2024 in achieving full employment in the U.S. So, with that in mind, we are likely safe from inflation pressures on corporate profits in the near-term but likely not safe from higher rates for some period.

Borrowing Costs/Leverage- Balance Sheet
Other factors putting downward pressure on valuations, by reducing available cash flows, are increased borrowing costs and on leverage (the amount of debt already outstanding for a given company and its ability to pay the interest expense). These factors can cause significant impacts to corporate health and available cash flow especially for companies teetering on the edge of below investment grade ratings or even solvency.

To understand fully, corporate borrowing costs are dependent on credit quality and are based off the prevailing risk-free rate, i.e., the U.S. Treasury yield curve. And, due to corporations lacking authority or ability to print unlimited money to pay their debt expense, like the U.S. Treasury, there is inherent default risk associated with corporate debt. Therefore, the market will price corporate debt by taking a similar maturity U.S. Treasury issue and adding a spread to it (Yield Spread). The spread can range from .25% – .50% (alternatively referred to as 25 – 50 basis points) for investment-grade companies like Microsoft or Johnson & Johnson to greater than 5.00% (500 basis points) for below investment-grade, or high yield, companies such as Ford Motor Company.

The yield curve is one of the primary determinants in setting the interest rate for new corporate bonds, along with the amount of leverage already being used, so a .50% – 1.00% (50 – 100 basis points) upward shift in borrowing costs would be another downward pressure on available cash flows. Not to mention, as credit quality deteriorates for a given company, there is friction in raising capital through new bond issuance as a company’s legacy debt investors might be constrained by a lower credit rating or a perceived lack of quality of newly issued bonds.

However, of the issues mentioned in this commentary, the balance sheet effect is likely the least impactful in the short-term as corporate treasurers have exhausted refinance efforts in the face of historically low-rate levels over the last decade. The companies most at risk, are the lower quality, below investment grade borrowers such as middle-market energy, telecommunication, and financial services, who have generally higher debt-to-equity ratios, with debt maturities less than ten years and the need to issue new debt more frequently. Nonetheless, this can lead to pressure on valuations as investors see higher rates persist. At the end of the day, it might not take much of a move to put pressure on corporate balance sheets.