If you’re in search of something to finish a conversation fast so that you’re at peace with your investment and other financial matters, then you should start talking on interest rates. Your audience’s eyes are sure to be filled with glee and you’ll be on your own within a matter of minutes.
However, for those with investment portfolios, the subject isn’t as bleak as you may think. It’s actually something investors must try to comprehend. According to the theory of finance, interest rates are a major factor in valuation of companies, and have a major impact on the way we set prices on stocks.
Interest Rates and Risk Premium
Consider that interest as the price of money. This, as the cost of production costs of labor and other expenditures is a determinant of the company’s financial viability.
The primary cost of the money an investor pays can be found in that of the Treasury notes rate which is assured through government guarantees of “full faith and credit” of the U.S. government. 1. According to the theory of finance that a stock’s value is based on the fact that Stocks are considered to be risky assets. They are much more risky than bonds due to the fact that bondholders receive their capital prior to stockholders in the case of bankruptcy. Thus, investors need an increase in return when taking on additional danger by investing in shares, instead of Treasury notes which guarantee an amount.
The extra profit that investors might expect from stocks is known in the form of the “risk premium.” Historically, the risk-free rate can be found at around 5 percent. This means that if risk-free rate (the Treasury note rate) is 4 percent, investors will expect an annual return of 9 percent on a stock. Thus, the return of a stock is the sum of two components which are the risk-free rate and the premium for risk.
If you are looking for higher returns, it is recommended to bet on riskier stocks since they carry an increased risk-to-risk ratio as opposed to, for example, more stable blue-chip firms. In the theory of rational investors, they will choose an investment that has the highest return enough to make up for the loss of interest from the guarantee Treasury note, and also to take risks.
Required Rate of Return
If the return required increases then the stock price falls in reverse, and reverse. This is understandable If there is nothing else to change the price must be lower in order for investors to earn the desired return. There is an inverted relationship between the return required and the price that the investors put on the stock.
The amount of return required could increase depending on whether the risk-free rate or the risk-free rate is increased. For example the risk-free rate could increase for a business when the company’s top management is fired or if the firm abruptly decides to reduce the dividends it pays. The risk-free rate could increase if interest rates increase.
Thus fluctuations in the interest rate can affect the value theoretically of companies and their shares. In essence the fair value of a share is the projected cash flows, which are discounted to the present , using the investor’s minimum yield. If interest rates drop and all other factors remain the same, shares’ value will increase. This is the reason why the market usually rejoices whenever it is announced that the U.S. Federal Reserve announces cuts in rates. In contrast, if the Fed increases rates (holding all other variables constant) shares are expected to decline.
How Interest Rates Affect Companies
The impact of interest rates on a business’s operations, too. Any rise in the interest rates it has to pay will increase the expense of capital. So, companies have to make more effort to earn more profit in a high-interest environment. In the event that it fails, the huge interest cost will chip off its profits. A lower profit margin as well as lower cash flow as well as a higher requirement that investors earn translate to lower fair values for the company’s stock.
In addition, if interest increases to such an extent that the business is unable to pay its debts, then the company’s survival could be at risk. If that happens investors would be able to demand a more risky risk price. In the end, the fair value will drop even more.
Additionally, high-interest rates typically are associated with a slow economy. They stop people from purchasing items and businesses from investing in opportunities for growth. This means the profits and sales drop and share prices drop.
The Bottom Line
In the realm of finance, the concept of valuation starts with a basic question: if you invest money into this business then what are the odds you’ll get a better return than investing in another? The interest rates play a crucial factor in determining what other thing could be.
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