In every one of the seven phases of rising interest rates over the previous four decades, the US S&P500 12-month forward price-to-earnings ratio declined.
The multiple at which investors are willing to pay for a company’s earnings also declines whenever inflation or interest rates rise. Therefore, the bulk of their profits are in the future, as opposed to a Wesfarmers or BHP. However, they both invest heavily in future growth projects, thus foregoing current profitability for potentially greater future profitability. These two companies are phenomenal businesses. Two examples of these high-growth companies are Xero and NextDC. When cash flows are further out in the future, the heavier the discount and thus the lower the present value of the cash flows. For example, cash-generative businesses such as Woolworths and Coles. This consequence is particularly true for ‘high-growth’ companies, as the bulk of their cash flows are typically expected to occur further out in the future compared to more stable companies. Therefore, each dollar of future earnings is worth less today when interest rates are expected to be higher. Higher interest rates increase the rate, at which future cash flows are discounted. Interest rates can be compared to gravity when it comes to their impact on stock valuations. However, the derived target price serves as a rough indicator of value. Of course, key assumptions about a company’s future are made to be able to calculate a company’s intrinsic value, where these assumptions are inevitably not going to be exactly right. If you divide this value by the amount of shares a company has issued, you get the intrinsic value per share and the price at which you should be aiming to buy a company’s shares at or around. If you conclude all the annual cash flows a company is expected to produce in the future, discount them by an interest rate to account for the time value of money and add them up, you derive a company’s intrinsic value. A company’s fundamental value represents the current value of all the future cash flows, that the company is predicted to produce.
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