Interest Rates Explain This Year’s Stock Price Declines
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
This year’s horrible market performance is Russia's fault, cries the media. Others put blame for recent stock declines at the feet of the Federal Reserve. Some fault Biden, the dollar, or OPEC. The financial media likes to have definitive explanations for every market gyration.
But few media professionals (Advisor Perspectives excepted) realize that a simple Finance 101 formula accounts for about 90% of recent stock market losses. On the other hand, maybe they just don't care. Biden, Russia, and OPEC garner many more viewers and advertising dollars than financial formulas.
This article explores the discounted cash flow model (DCF) and the discount rate embedded in stock valuations. The DCF model provides critical insight into how interest rates affect stock prices. Appreciating how the recent surge in yields impacted stock prices, we can focus on the future path of interest rates and earnings to formulate a clearer picture of where stock prices may be heading.
Whether buying shares of Apple or a stake in a local grocery store, you are sacrificing current capital in exchange for future cash flows. Accordingly, our job as investors is to calculate a fair price for said cash flows. First, we need to forecast the cash flows. Then we need to calculate their present value using an appropriate discounting factor.
The DCF model, a staple in entry-level finance classes, allows us to formulate a present value of future cash flows. The following example helps us appreciate the model.