Interest rates: let's put numbers on the long term vs. short term impact

The lower the interest rates the less relevant current temporary fluctuations in earnings are for the value of a business. Equally, the lower the interest rates the more important it is to understand the future earnings prospects of a business. This is a well-known fact, but putting some numbers to it could help to get a clearer sense of it.

It is widely accepted that the value of a business is determined by its future net cash flows, discounted at an appropriate rate (DCF). Regardless of how you want to calculate this discount rate, its value is correlated to interest rates.

Interest rates and short termism

I find little sense in the meticulous attention that some analysts pay to quarterly results and quarterly projections. Because they most likely value the business using a discounted cash flow model, which projects to infinity.

Naturally what happens in a quarter or even in one day could be very important if it reflects a substantial change to the business, that will have a profound impact on its future (a meteorite hitting the headquarters could be a good albeit extreme case example). Otherwise, short term events have very little impact on the intrinsic value of a business, but they are too often the main focus of analysts and investors.

Let’s take a look at a disrupted business scenario. A business shuts for a year, returns to normal operation afterwards and continues operating forever generating flat earnings. If we assume a 10% discount rate, its intrinsic value falls 9% compared to if it had not shut. For its value to reduce by 50% it would need to shut for 8 consecutive years!

The loss of intrinsic value would be lower if the discount rate were lower.

The following tables show the reduction of intrinsic value compared to uninterrupted operation in relation to

• the number of consecutive years during which the business shuts down, starting from next year

• the discount rate

Interest rates and earnings growth

In a low interest rate environment, earnings growth has greater impact on the intrinsic value of a business. The following table shows the change of intrinsic value compared to stationary uninterrupted earnings in relation to

• earnings CAGR

• the discount rate

There are two corollaries to this:

• when interest rates decline, the value of businesses that grow their earnings at a faster rate will increase more

• when interest rates increase, the value of businesses that grow their earnings at a faster rate will decrease more

For example, if the discount rate decreases from 10% to 5%, the intrinsic value of a business that grows its earnings at 2% in perpetuity would increase by 127%; whereas the intrinsic value of a similar business that instead grows its earnings at 4% in perpetuity would increase by 212%.

August 2021