How Interest rate changes effects your stocks.

How the Balance sheets of corporates are affected:
1) Take banks and financial institutions.
Calculating their impact is simple. They pay the depositors a particular interest rate and buy treasury bonds, or distribute it as loans. Many of the fixed deposit, bonds have fixed rates which need to be honored irrespective of the present conditions. So a fall in the interest rates causes higher profits and vice versa.

2) Leveraged industries
These are companies which have taken huge loans for their new plant, expansions etc. Any rise/fall in the interest rates has huge impacts in the interest outgo, hence the profitability.

3) Fall in the sales
The real estate is rising because the interest rates are low and it if often cheeper to pay an EMI then to pay a rent. A rise in interest rates greatly effects the spending of consumers and corporates, less houses, machinary and cars will be bought leading to a slowdown in the production and revenues of the corporates and hence lower profits.

Common sense says, most IT companies, and established Business houses have little or no debt, so their valuations should not be impacted much. But no:

1) Growth oriented companies:
They are traded at very high PE ratios, because their revenues are expected to increase by 30-40% each year and this expectation of future earnings beef up their stock prices.
100 rupees 5.5% interest grows by 1.7 over 10 years but will grow to 1.8 if interest rates is increased to 6%. So any change in interest rate changes the present value of the future earnings and hence changes the stock price.

2) Stable companies:
Their impact is also almost the same. If bond market gives 5.5%, you expect that your blue chip stock gives you at least 7% (1.5% risk premium) through dividends and stock price appreciation. Now if the interest rate increase to 6%, the only way you will get (6 + 1.5 = 7.5%) returns is that if the stock value dips from 100 to 99 ( .5% change in interest rate cause a 1% dip in the stock price)

 

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