Monetary Policy and Its Impact on Stock Valuations
By Scott Richards, Senior Manager, Advisory Services
The Federal Open Market Committee (FOMC) periodically adjusts interest rates on Fed funds to meet the dual mandate, set by Congress, to keep prices stable and maximize employment. Simply put, when the Fed perceives that the economy is overheated it raises rates, and when economic activity slows too much, producing high unemployment, the Fed lowers rates.
Without going into detail about the specific factors the Fed considers when making rate changes, looking back at the Fed’s reactions to relative strengths or weaknesses in the economy over the last 20 years can show how they accomplish their mandates.
Monetary Policy Shifts in the Last Two Decades
- Weak expansion followed the 2001 dot-com stock market crash. The Fed cut rates twice between November 2002 and June 2003 to stimulate employment growth. The S&P 500 increased by 9.1% between November 1, 2002 and June 30, 2003.
- The U.S. economy returned to strong economic growth in 2003 and 2004. The Fed increased rates 17 times between June 2004 and June 2006 to slow the housing boom and economic expansion.
- The housing market weakened in late 2006 and 2007. The Fed cut rates seven times between September 2007 and April 2008 to foster growth. This was followed by additional cuts in late 2008 to combat the Great Recession. Despite these cuts, the S&P 500 declined by 49.4% between August 31, 2007 and March 31, 2009.
- A long period of economic expansion took place between 2009 and 2018. The Fed raised interest rates nine times between December 2015 and December 2018 to moderate expansion and inflation.
- Rates were eased in 2019 to stimulate growth — then the COVID-19 pandemic hit. The Fed made two rate cuts in March 2020 in an effort to stimulate growth as the economy stalled, and rates remained at historically low levels between March 2020 and March 2022, when the latest round of increases began. The S&P 500 increased by 60.8% between July 1, 2019 and December 31, 2022 due to lower interest rates and significant economic stimulus payments, among other factors.
- The highest inflation levels since the early 1980s took place in late 2021 and 2022. The Fed’s strategy to fight high inflation was to raise interest rates six times between March 2022 and November 2022, including four consecutive 75 bps increases (as shown below). As a reaction to these increases, the S&P 500 declined by 17.0% between March 31, 2022 and November 2, 2022.
This historical perspective indicates that there is a correlation between changing interest rates and stock prices in general, as stock markets react to changes in interest rates. Stock prices generally rise when rates drop and decline when rates rise. Stock prices can be influenced by changes in both short-term and long-term interest rates. Consider that the 20-year, constant maturity U.S. Treasury bond yield increased 181 bps — to 4.41% from 2.60% — between March and early November 2022.
All other factors remaining constant, if a larger percentage of each dollar a company earns is used to pay interest to debtholders, then a smaller portion is available for shareholders to fund growth or pay dividends. Absent other influences, this factor lowers stock prices as shareholder returns shrink.
In part, the stock market decline in 2022 is a classic example of the reaction to much higher interest rates on the horizon as the Fed tried to stem inflation with this tool. The Fed’s policy statements indicated that its aggressive efforts were needed because a strong economy and jobs market produced historically high inflation. While the ultimate result of this measure is yet to be seen, the impact on stock prices in the public markets is undeniably negative.
Private Company Valuations in Periods of Rising Interest Rates
How do changes in interest rates impact private company valuations? The market rate of interest as of the valuation date changes the discount rate used in a discounted future cash flow method (DCF), or it changes the capitalization rate used in a single-period discount model. When applying either method, a major component of determining the discount rate is the risk-free rate (RFR) as of the valuation date. The following example shows how the change in interest rates between March 17, 2022 and November 2, 2022 (the dates of the first and latest interest rate hikes in the current cycle) impacted the capitalization rate based on the following assumptions:
|Risk-free rate:||2.60% at 3/17/2022 and 4.41% at 11/02/2022|
|Equity risk premium:||6.0%|
|Company-specific risk adjustment:||3.0%|
|Long-term growth rate:||3.0%|
|Company borrowing rate:||Prime interest rate as of valuation date +200 bps|
|Capital structure:||80% equity; 20% debt|
|Income tax rate:||3.5%|
Based on the above assumptions and calculation of the capitalization rate as of each valuation date, with the sole change being the risk-free rate, the fair market value of the equity capital calculated using the capitalization of income method under the income approach would be approximately $8,750,000 as of March 17, 2022, and approximately $7,005,000 as of November 2, 2022. That’s a decline of 19.9%, solely due to higher interest rates. As we have seen a similar decline in the public stock markets, the recent increase in interest rates captures the changing market conditions in the current environment. We should note that this may not always be the case, and valuation experts must consider all factors as of a valuation date.
Another commonly used valuation approach is the market approach. In applying a guideline public company approach, it incorporates the market values of both equity capital and borrowed capital as a starting point to develop appropriate market value ratios. It is important to examine the terms of each debt component, especially in times of fast-rising interest rates, as any fixed-rate debt may not be worth its book value. The same is true for any fixed-rate preferred stock included in the equity structure.
Given a weakened economy and the Fed’s measures to confront inflation, including rapidly rising interest rates, now may be a good time to consider transferring interests in privately held businesses. Lower valuations, coupled with the currently high lifetime gift tax exemption of $12.06 million (for 2022), make this an opportune time to leverage gifts into significant estate tax savings in the future. Keep in mind that the lifetime exemption amount is currently scheduled to sunset in 2026 to half of its then-current level.