How Interest Rates Impact Share Prices

Understanding the relationship that rising interest rates have on share prices

Why do share prices fall when interest rates rise?

 Company shares are typically valued using a discounted cash flow valuation also known as a DCF. A key input into a DCF calculation is the discount rate. The discount rate has an inverse relation to the value of the companys share. If you increase your discount rate the value of the company falls. If you decrease your discount rate the value of the company rises.

So how does a change in the interest rate affect the discount rate?

 In a DCF valuation shares are discounted at a discount rate that reflects the WACC of the company. WACC stands for the weighted average cost of capital. The WACC of a company is a combination of the cost of debt of the company and the cost of equity. The cost of debt, in a nutshell, is the interest a company pays on its long-term debt that forms part of its capital structure. So when interest rates, rise so does your cost of debt, as the interest rate on your debt has increased. Thus when your cost of debt rises so does your WACC (discount rate).

A rising interest rate also affects your cost of equity. A cost of equity is calculated as the risk-free rate plus an equity risk premium. Interest rates directly affect your risk-free rate. A risk-free rate is a return you can get on a risk-free investment. The most common form of a risk-free investment is a government bond. The return on a government bond is directly correlated to the prevailing interest rate. Thus when your interest raises your risk-free rate raises and thus so does your cost of equity.

So to recap when interest rates go up:

1. Your cost of equity and cost of debt both increase
2. Cost of equity and cost of debt is used to calculate a companys WACC
3. WACC is used as a discount rate to value stocks in a DCF
4. When the discount rate used in a DCF raises the value of the stock decreases