How Interest Rates Impact Cash Flow Analysis

May 14, 2009 5:39 AM ET2 Likes
Andy Kern profile picture
Andy Kern
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A key and often under-appreciated variable affecting stock prices is interest rates. While most investors know that rate cuts usually help stock prices and rate hikes hurt them, an understanding of the importance of interest rates helps to illuminate the source of value within each stock. The process of discounted cash flow analysis is enormously dependent upon prevailing interest rates, and thus understanding rates also helps explain the inner workings of the RBP (required business performance) methodology.

In 1999 Warren Buffett penned an article with Carol Loomis for Fortune (available here) that argued that the stock market could not possibly do as well in the future as it had in the past. This was a shocking revelation amidst the go-go tech bubble when the market was pricing stocks at levels that implied enormous future revenue and cash flows. Ten years later, Mr. Buffett’s article seems particularly prescient.

Future cash flow and discount rate

A deeper look at his rationale is thus important today. A stock is worth the present value of some stream of cash flows that it will produce in the future. We can calculate this value by projecting out future free cash flows and discounting them back to present. The key variables, therefore, are the future free cash flow and the discount rate used in the calculation.

First, assume that our opinion of future free cash flow doesn’t change so as to isolate the effect that the discount rate will have on value. You can think of the discount rate as the opportunity cost of investing in Stock A over Stock B or Investment C. If interest rates rise, so too should our discount rate since we would have more opportunities to do more with our money elsewhere. And since discount rates and present values are inversely related, value will decline, all else equal, as the result of a rise in interest rates.

From 1964 to 1981, the stock market went exactly nowhere. In aggregate, no money was made by investors during this period. But yet GDP nearly quadrupled. How is this possible, you may ask. Well, also during this period, interest rates rose dramatically. The rate on long-term government bonds went from a mere 4.2% in 1964 to 13.65% as the 1980s began. This had a devastating effect on stock prices. Then, as we are well aware, from 1981-1998 stocks rose more than tenfold. This can easily be explained by the remarkable drop in interest rates – all the way from that 13.65% in 1981 to next to nothing at the start of this decade. (GDP growth, by the way, was actually lower in this second period than it was in the first.) This is why Buffett argued in 1999 that stocks could not do as well in the subsequent 17 years as it had in the previous.

It is easy to understand how interest rates affect bond prices. No one will want to buy a bond paying 6% if the going rate has risen to 8%, so the price drops. But keep in mind that the fundamental source of value for a stock is derived in the same way. Investors buy bonds to receive coupon payments in the future. Investors buy stocks to receive “coupons” that take the form of cash flows or earnings per share.

There are plenty of variables that will affect the stock market, but the one most fundamental to value is nearly certain to hurt stock prices. This was the argument Buffett was making in 1999.

Hopefully this explanation of interest rates makes it easier to understand where RBP comes from. A company’s RBP is calculated by taking the stock price and inferring, based on current interest rates, what performance the company must produce for the present value of those future cash flows to equal the stock price. The present value of those future cash flows, of course, is determined by using a discount rate that is a function of prevailing market rates. Thus, if market rates increase, the present value of those future cash flows decline and larger cash flows will be needed to justify the current stock price.

This article was written by

Andy Kern profile picture
78 Followers
Andy Kern is a PhD candidate at the Trulaske College of Business at the University of Missouri. His research interests are focused in the areas of bankruptcy and investments. He was formerly a principal and investment advisor representative a state-registered investment advisor in Missouri and is currently a managing member of Empirical Finance LLC. Mr. Kern has received widespread acclaim for the course he teaches at Trulaske called "The Investment Strategies of Warren Buffett" and has appeared in two CNBC documentaries about Warren Buffett. Mr. Kern also holds an MBA from the University of Missouri. In addition to his personal blog, Berkshire Ruminations (http://berkshireruminations.blogspot.com/), Mr. Kern authors RBP Investing (http://rbpinvesting.com/), the official blog of Transparent Value LLC and serves as a contributor to Empirical Finance Research (http://empiricalfinanceresearch.blogspot.com/), a blog highlighting practical academic research in finance.
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