If you're ever looking for a topic to help wrap up a conversation quickly so that you can be left alone to think about your investments, then start talking about interest rates. Your listener's eyes are guaranteed to glaze over, and you'll be alone in no t💙ime.

But for those who own investments, the topic is not as dry as you think. In fact, it is something investors should make an effort to understand. According to financial theory, interest rates are fundamental to company 澳洲幸运5官方开奖结果体彩网:valuation, and therefore play an important role in how we p𒀰ut a price on stocks.

Here we take a look at the relationship between interest rates and s𒁃tock price𒈔. 

Interest Rates and Risk Premium

Think of an interest rate as the cost of money, which just like the cost of production, labor, and other expenses is a factor of a company's profitability.

The fundamental cost of money to an investor is the 澳洲幸运5官方开奖结果体彩网:Treasury note rate, whose return is guaranteed by the "full faith and credit" of the U.S. government. According to financial theory, a stock's 澳洲幸运5官方开奖结果体彩网:value proposition starts there: stocks are risky assets, even riskier than bonds because bondholders are paid their capital before stockholders in the event of bankruptcy. Therefore, investors require a hiܫgher return for taking on extra risk by investing in stocks instead of Treasury notes, which are guaranteed to pay a certain return.

The extra return that investors can theoretically expect from stocks is referred to as the "澳洲幸运5官方开奖结果体彩网:risk premium." Historically, the risk premium runs at around five percent. This means that if the risk-free rate (the Treasury note rate) is four percent, then investors would demand a return of nine percent from a stock. Therefore, the 澳洲幸运5官方开奖结果体彩网:total return on a stꦬock is the sum of two part෴s: the risk-free rate and the risk premium.

If you want higher returns, you must invest in riskier stocks because they offer a higher risk premium than, say, stronger 澳洲幸运5官方开奖结果体彩网:blue-chip companies. In theory, rational investors will select an investment with a return that is high enough to compensate for the lost opportun⛄ity💖 of earning interest from the guaranteed Treasury note and for taking on additional risk.

Required Rate of Return

If the required return rises, the stock price will fall, and vice versa. This makes sense: if nothing else changes, the price needs to be lower for the investor to have the 澳洲幸运5官方开奖结果体彩网:required return. There is an inverse relat🍌ionship between the required return🔯 and the stock price investors assign to a stock.

The required return might rise if the risk premium or the risk-free rate increases. For instance, the risk premium might go up for a company if one of its top managers resigns or if the company suddenly decides to lower its dividend payments. And the risk-ဣfree rate will increase if intereᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚst rates rise.

So, changes in interest rates impact the theoretical value of companies and their shares — basically, a share's 澳洲幸运5官方开奖结果体彩网:fair value is its projected future cash flows discounted to the present using the investor's required rate of return. If interest rates fall and everything else is held constant, share value should rise. That's why the market generally cheers when the 澳洲幸运5官方开奖结果体彩网:U.S. Federal Reserve announces a rate cut. Conversely, if the F♓ed raises rates (holding everything else constant), then share values are likely to fall.

How Interest Rates Affect Companies

Interest rates impact a company's operations too. Any increase in the interest rates that it pays will raise its 澳洲幸运5官方开奖结果体彩网:cost of capital. Therefore, a company has to work harder to generate higher returns in a high-interest environment. Otherwise, the bloated 澳洲幸运5官方开奖结果体彩网:interest expense will eat away at its profits. Lower profits, lowe🌃r cash inflows, and a higher required rate of return for investors all translate into🐭 depressed fair value for the company's stock.

Additionally, if interest rate costs shoot up to such a level that the company has problems paying off its debt, then its survival may be threatened. In that case, invest𒈔ors will demand an even higher risk premium. As a result, the fair value will fall even further. 

Finally, high-interest rates normally go hand-in-hand with a 澳洲幸运5官方开奖结果体彩网:sluggish economy. They prevent people from buying things and companies from investing in growth opportunitie🦋s. As a result, sales and profits drop, as do share prices.

The Bottom Line

In financial theory, valuation begins with a simple question: if 🐷you put money into this company, what are the chances you will get a better return than if you invest in something else? Interest rates play an important part in determining what ꩵthat something else might be.