What You Need to Know
- Cash flows that extend into the future, divided by an interest rate, is a simple way to discount future cash flows back to today to give us a price.
- The rate used to discount these cash flows is incredibly important.
- The author believes it makes sense to have value exposure for the remainder of 2021.
Interest rates have moved higher on increased inflation expectations given the combination of a reopening economy and crazy amounts of stimulus everywhere you look.
This rise in rates has affected growth and value stocks differently. We always break down stock returns into three components:
- +/- Valuation change.
Rising rates could lead to a headwind for any stock that’s priced for perfection, because of return driver No. 3: valuation change.
A company’s stock price is simply the value of future cash flows discounted by some interest rate. Think about the math of that: A series of cash flows that extends way into the future (the numerators), divided by an interest rate (the denominator), is a simple formula for discounting future cash flows back to today to give us a price.
For added simplicity and to hammer home the next point, let’s take one future cash flow of $100 arriving in 10 years, and discount it back to today. We will do this twice — first using 0.50% as our denominator, then using 5.0%.
Using 0.50%, today’s value of that future cash flow is roughly $95.13.
Using 5.0%, today’s value would be roughly $61.39.
Hopefully, our point is jumping out at you. The rate used to discount these cash flows is incredibly important.
The lower the discount rate, the higher the value attributed today to future cash flows of tomorrow — and vice versa.