The markets have been spiralling downwards. Yes, inflation, interest rate hikes and all that!
The connection with inflation is rather obvious - spending power reduces and revenue drops; costs increase and profits drop.
But the fall in stock prices is more than the expected drop in earnings. Welcome subdued valuations!
How are stock prices determined?
A company’s stock price, in simplistic terms is the sum total of its future cash flows at present. However, what’s 100 ten years later is not a 100 today. It has to be discounted. When interest rates rise, the discount rate increases. The denominator goes up, today’s value reduces.
What makes the discount rate go up?
The discount rate usually takes into account the cost of capital. When interest rates rise, the cost of capital increases. And hence the higher discount rate.
Beyond this, there’s also something known as a risk premium. If a government were to take a loan, the risk premium would be low because the chances of a government not repaying the debt would usually be negligible. However, when a company takes a loan, that too in a tough economic environment, there is a risk premium involved. In the current scenario, the risk premium goes up, further pushing the discount rate higher.
And then there is sentiment
While the above was theoretical, in essence a stock’s price can also be looked at as a function of
Earnings
What investors are willing to pay for those earnings
In a rising rate scenario, the cooling down of the economy is intended. Risk aversion of investors increases. Earnings are going down, the markets are under stress, growth is at risk, and investors are willing to pay lesser for each rupee earned by the company compared to before. That itself reduces the valuation.
Valuations hurt more
Let’s start with an example here. A stock’s price is 100. Earnings per share = 10, and PE of 10. Essentially, of the 100, 10 comes from the earnings, and 90 from the valuations. When valuations fall, they dramatically hurt stock prices.
What to do?
A good strategy to use during times like today is to invest in the following attributes:
Companies that have earnings that are strong and resilient, and less prone to shocks compared to other companies
Companies where earnings growth expectations don’t get materially hampered, as valuations tend to then fall dramatically
Companies with lower valuation premiums compared to the market and peers
Companies that provide some additional form of comfort in the form of high dividends
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