The recent May 2023 interest rate hike by the South African Reserve Bank (SARB) marks the tenth consecutive since November 2021 as it struggles to keep inflation within target ranges. Whilst the April 2023 Consumer Price Index (CPI) of 6.8% has cooled from the March 2023 figure of 7.1%, the CPI is still sitting outside of the SARB’s inflation target range of 3-6%, and as such, it is unlikely that any reprieve is expected over the remainder of 2023. Given this environment, it becomes increasingly important to understand the impact of interest rates on company equity valuations.

A cornerstone of valuations is the principle that higher-risk investments require higher returns. This speaks to the cost of capital, where market participants (both debt and equity holders) require varying levels of returns based on the risk they take on through the investment.

There are numerous techniques that can be used for the valuation of equity. However, at a simplified level, a company’s intrinsic value is determined by estimating the present value of its future cash flows. This estimation of value is forecasting what cash flows will be available to equity participants in future periods and how these future cash flows translate to current value accounting for the varying rate of return that market participants require.

Understanding the complexities of monetary policy on cash flows and discount rates will be critical when unpacking the impact interest rate hikes have on valuations.

The Weighted Average Cost of Capital (WACC) is the most common approach when performing a Discounted Cash Flow (DCF) valuation, as this method weights the cost, both of debt (required rate of return of debt) and equity (required rate of return of equity) based on the optimal capital structure of the entity. The cost of equity is developed starting with a risk-free rate, being the rate of return for an investment with zero risk. Adjustments for default risk, company-specific risk premium, country-specific risk premium, and equity risk premium are then made to this risk-free rate in calculating the cost of debt and cost of equity.

Government bonds are often used as a proxy for the so-called risk-free rate, and changes in interest rates directly impact bond yields, thereby impacting the risk-free rate. When interest rates are low, market participants are more inclined to invest in riskier investments, as the returns on safer investments are relatively low. As a result, low-interest-rate environments often lead to higher stock prices and company valuations.

Country-specific and company-specific risk premiums may also change as a result of potential changes in the composition of revenue streams, exchange rates, debt-to-equity mix, economic stagnation/downturn, etc., as an effect of the change in monetary policy.

As such, changes in interest rates will result in increases in the risk-free rate and impact on business fundamentals and market sentiment. All of which will result in changes to the required rate of return and discount rates. By inference, interest rate hikes may result in disproportionate increases in valuations’ discount rates.

The resulting impact of this change in the discount rate is the decrease in the valuation of the company, as cash flows are discounted at a higher rate given the increase in the required rate of return.

More often than not, interest rate movements impact overall business performance. However, this impact will change from company to company, with some industries seeing top-line growth with increasing interest rates (e.g., Banks), and other highly leveraged companies will experience a squeeze on cash flows and decreasing net profit. The potential reduction in the ability of a business to service its debt may put pressure on its cash flows and profitability and, further, may result in changes to the risk profile and growth rate of a company resulting in an impact on the overall equity value.

The effect of interest rates on discount rates is an obvious correlation, and although valuations are more sensitive to changes in discount rates, understanding the effect of interest rates on cash flows is critical to understand when determining how a fluctuating interest rate may influence the overall valuation.

Additional consideration should be given to the timing of cash flows. Given the impact of the time value of money brought in through the discount rate, cash flows pushed out further into the forecast will decrease the entity’s overall value. Resultantly high-growth companies will usually see more considerable erosion in the valuation of their equity than value-based companies when interest rates are hiked.

Where foreign revenue streams exist, it is crucial to consider that interest rate hikes offer lenders a higher return relative to other countries. As such higher interest rates attract foreign capital and cause the exchange rate to strengthen, which may, amongst other impacts, result in changes to the composition of currency-based earnings. This, too, adds complexity to the valuation process.

The terminal value of an entity usually comprises a large component of its value and thus carries its own risk profile. Assuming the company intends to continue as a going concern, a terminal value must be calculated. Discounted cash flow models are highly sensitive to the terminal growth rate applied, and as such much care must be given when assessing the valuation of this input.

The basic principle of the stable growth rate precipitates that the company’s growth into the foreseeable future cannot exceed that of the economy in which it operates. Further, as the risk-free rate will converge on the economy’s growth rate over the long term, a ceiling can be placed on the stable growth rate equal to the risk-free rate. This, however, does not mean that the growth rate cannot be less than the risk-free rate and factors such as which economies the company operates in, the length of high growth period(s), the long-term debt-to-equity mix, reinvestment, and retention ratios, and the transition to stable growth are all critical factors to understand in developing a terminal value.

As the stable growth rate cannot exceed the risk-free rate, changes in the interest rate may impact the potential ceiling. It could also be argued that the interest rate could impact many of the factors discussed above. However, the interest rate will likely have a minimal impact on stable growth rate and terminal value, as the interest rate changes are a more short-term view and are unlikely to impact the metrics used to measure perpetual growth which necessitates a long-term view on stable growth.

Where multiple-based methodologies are employed, adjustments to multiples based on interest rate changes may be needed, given that the historic multiples are based on risk premiums for market sentiment and projected expectations on growth rates. These adjustments hold a higher degree of estimation uncertainty and are less likely to give an accurate insight into the value of equity.

One, however, needs to consider the current state of affairs and whether or not the current interest rate environment has been priced into the market and ultimately accounted for in the current and forward trading multiples of comparables. More often than not, the market (acting diligently) would have these priced in, and therefore no further adjustments would need to be made to avoid double counting, however, this does remain a key consideration when using a multiples-based approach.

While interest rate changes are likely priced into current trading multiples of comparable businesses, it is essential to consider additional adjustments when valuing highly leveraged entities.

Foreign investment and mixed currency revenue streams complicate understanding interest rate hikes and monetary policy changes on equity valuations. Interest rate hikes in foreign countries can result in increased profitability of local companies.

Changes in interest rates can have a myriad of impacts on valuations, both on the cash flow projections and discount rates utilised. Where there is complexity, caution should be exercised in ensuring the completeness and accuracy of adjustments, especially as double dipping for the related impact of interest rate hikes can often occur. It, therefore, becomes imperative to have a clear and defined approach to building in macroeconomic changes to model-based valuations. While complexity is involved, it does stand true that a higher interest rate environment will likely dampen a company’s valuation.