It’s a well-known fact that lower interest rates are good for the equity and property markets. The obvious drivers are:
- Consumers have more disposable income to spend after paying their debt, which increases business profits
- Cheaper debt lowers financing costs particularly for property, which is usually geared, increasing business profits and net rentals
Higher profits / rentals translate into higher valuations. This seems very logical, but to really understand why interest rates are so important to stock markets, investors must understand how financial assets are valued.
As a shareholder you are a part-owner of a business and your shareholding entitles you to a share in the future profits of the business. The value of the business and therefore the value of the underlying shares in the business; is simply the value of future earnings, in perpetuity, discounted to a present day value using an appropriate “discount rate”. Sounds very theoretical, but this is the basis for valuing all financial assets.
The “discount rate” is very complex and beyond the scope of this article, suffice to say interest rates are used in calculating the discount rate. The higher the discount rate the lower the present day value of future earnings and vice versa; the lower the discount rate the higher the present day value. Thus low interest rates justify higher share prices, best illustrated by a calculation. R 100 000 per year profit discounted at 10% equates to an asset value of R 1mil. Reduce the discount rate to 5% and the asset value increases to R 2 mil.
Determining the value of a property and / or share in a business is very complex affected by numerous variables / factors; however the underlying valuation methodology of discounting future earnings is the very foundation of the valuation process, this is why interest rates will always remain critical in determining asset values and should not be ignored by investors.
The trick is staying ahead of the curve by predicting future interest rates moves. If you figure this out please let me know how!
Mcomm, CFP®, HdipTax
T. 021-205 1133