Warren Buffett once said interest rates were the most important thing in determining whether a stock was cheap or expensive.
A high interest rate means higher cost of equity, which lowers stock valuations, while a lower interest rate means lower expected returns, which translate to higher stock prices.
The cost of equity, computed by simply taking the sum of a risk-free interest rate and a risk premium, is the price that we are willing to pay for a risky asset.
For example, the cost of equity of First Gen Corp. in January last year was 7.9 percent. If the 12-month earnings per share of the stock was P4.12, the price that we would be prepared to pay for it, given our expected returns, should be P52.4 a share.
We computed this, which represents the value of the stock’s earning assets, by dividing its earnings with our cost of equity.
We computed for the cost of equity by taking the sum of the 10-year Philippine bond yield of 4.6 percent at that time and a risk premium of 3.3 percent.
Because interest rates have fallen significantly last year, in an effort of the government to boost economic activities, the 10-year bond yield has also gone down from 4.6 percent to 3 percent today.
At a lower interest rate, First Gen’s cost of equity has dropped from 7.9 percent to 5 percent.
The lower cost of equity has raised the value of the stock’s earning assets by 38.8 percent from P52.4 a share to P72.7, despite an 11.9-percent contraction in earnings.
Such increase in valuation has resulted in a share price growth of 43.3 percent from P20.79 a share last year to P29.80 last week.
Interest rates have played a pivotal role in the rise of the stock market in the past years.
During the 2008 bull market, it was the fall in interest rates from 9.6 percent in 2008 to 3.5 percent in 2013, as represented by the 10-year bond yield, that powered the Philippine Stock Exchange Index (PSEi) to rise by more than 300 percent.
When interest rates stabilized at the 4 percent level, it was the low interest environment in 2014 to 2016 that sustained the PSEi to rise further.
But in 2017, when interest rates started to go up, the rise in average cost of equity, from 9 percent to 11 percent, made the stock market overvalued, which topped out in early 2018.
Last year, the fall in interest rates to 4.6 percent has restored the average cost of equity to 9.4 percent, which helped the PSEi to recover by up to 80 percent from its historic low.
With interest rate now falling further to 3 percent, the average cost of equity is down to 7.45 percent.
The lower cost of equity would have increased the average value of PSEi stocks’ earnings assets by 21.5 percent, but because the average 12-month earnings contracted by 30.7 percent, the average value of assets fell by 19.9 percent.
The fall in valuation resulted in an 11.4-percent drop in the PSEi from the same period last year.
With the worst behind us now, a recovery in the economy, albeit slowly, should help improve earnings this year from a low base in 2020.
Expected higher earnings along with lower cost of equity will mean higher stock market valuation, which should support the PSEi to go up.
Although the recent rise in inflation can pose a risk that could increase the average cost of equity, interest rates are likely to remain low given the current economic situation.
With a low interest rate against a rising inflation, a negative real interest rate will make investing in the stock market all the more compelling as investors look for higher returns.
Low interest rates amid a recovering economy offer great opportunities in the stock market. As Warren Buffett said, “If interest rates are destined to be at low levels … it makes any stream of earnings from investments worth more money.”