How Rising Interest Rates Shake Up Stock Valuations: A Prudent Investor's Guide

Unravel the Complexities of High P/E Ratios in our Latest Blogcast

Update #508 22Jun23 $AMZN $MSFT $COST $TRP $MFC $AMGN $GPN $MMM

Join John and Raymond in this BlogCast as they delve into the complex world of rising interest rates and their effect on stock valuations. Through practical examples, they highlight the importance of substantial earnings growth for high valuations. In today's high-interest-rate environment, they advise a cautious approach.

Audio

Here’s a synthesized audio playback of the Purple Chips call between John and his associate Raymond. You can adjust the playback speed.

Transcript

Raymond: A warm welcome to you, John.

John: Thank you, Raymond, and good morning to you.

Raymond: On the table today is a fascinating exploration of the nuanced interplay between interest rates and stock valuations. I understand you've prepared several examples to shed light on this dynamic, specifically focusing on companies with high and low P/E ratios. Shall we dive right into it?

John: Absolutely, Raymond. It's an interesting time for investors as we've observed a drastic shift in interest rates over the past year, climbing from near-zero to around 7% for consumer borrowing.

Raymond: Indeed, and this prolonged near-zero interest rate environment has certainly influenced the strategic decisions of many companies.

John: Precisely. The decline in interest rates over the past two decades has recently shifted, and this change could significantly impact the stock market. Initially, it's important to note the size of the fixed income market, about two and a half times larger than the stock market, totaling roughly $300 trillion, compared to global stock markets worth about $125 trillion.

John: Due to its size, the fixed income market naturally attracts more investment. The guiding principle here is that capital tends to flow towards the area where it can generate the highest quality returns with the least amount of risk. Hence, it's crucial to compare the two when analyzing the stock market.

John: In the setting of rising interest rates, it's key to understand the inverse relationship between interest rates and stock market multiples. As interest rates rise, stock market multiples generally decline. This happens as investors often move their capital from the higher-risk stock market to seek lower-risk, higher-return opportunities in fixed income.

John: So, as we see interest rates remaining high or escalating further, we can expect a depreciation in valuations or P/E multiples. Now, one may wonder what constitutes an acceptable valuation or P/E multiple. Drawing from my stock market experience, a P/E multiple exceeding 35 times may not be sustainable. This is because such a high P/E implies that a company needs to deliver substantial annual earnings growth of greater than 35%, to justify the high valuation.

Raymond: Could you give us some examples of companies with such P/E ratios?

John: Certainly. Tech companies like Amazon and Microsoft come to mind. Amazon currently trades around 100 times earnings, which is quite lofty. Microsoft, trading around 35 times, is bordering the risky threshold. Despite its recent value appreciation, largely due to its investment in AI projects such as ChatGPT, we must remember we're still in the early stages of AI development.

Raymond: So, a P/E of 35 implies a requirement for a company to grow its earnings by around 35% a year, correct?

John: Exactly. This becomes clear when we compare tech companies to banks. Bank stocks usually trade around 10-14 times earnings and typically see an annual growth rate of 7-9%. Conversely, tech companies with a P/E multiple of 35 times are essentially pricing in growth rates that exceed the multiple.

John: here’s an example in the consumer staples / discretionary sector. Costco is a wonderful company, but with a P/E multiple of 38 times, one must question whether such a high valuation is sustainable.

John: Conversely, some companies with reasonable P/E ratios include TC Energy (12 times earnings), Manulife (8 times), Amgen (13 times), Global Payments (10 times), and 3M (11 times). Given their track records, these seem to offer attractive valuations.

John: Considering the current high-interest-rate environment, we can expect money to shift from the stock market in search of investments offering decent returns with less risk. Consequently, avoiding stocks with exorbitant multiples might be the prudent approach.

Raymond: John, is there a specific P/E multiple beyond which you'd consider excessive, or perhaps a midpoint that separates attractive and risky investments?

John: Great question, Raymond. If we look historically, the average P/E multiple for the stock market is around 16-17 times, assuming interest rates higher than zero. With current consumer interest rates around 6-7%, a reasonable level for the stock market could be around 16 times earnings. The caveat here is, for high P/E multiples to be justified, the company must demonstrate significant growth to substantiate that high multiple.

John: In our current environment, with high and potentially rising interest rates, it's reasonable to expect P/E multiples to gravitate towards the lower end. That, in essence, is the key takeaway from our discussion.

Raymond: Excellent analysis, John. We certainly appreciate your insights.

AI Research notes

The Price-to-Earnings (P/E) ratio is a tool investors use to evaluate the valuation of a company's stock. It's calculated as the current share price (P) divided by the earnings per share (E). Interest rates, set by a country's central bank, represent the cost of borrowing money and can have wide-ranging effects on the economy, including on stock market valuations and P/E ratios. Here's how they interact:

• Discounted Cash Flow (DCF): If interest rates are high, the present value of a company's expected future earnings decreases. Investors, when valuing a company, may expect lower future earnings, given the higher discount rate. If the "E" (earnings) in the P/E ratio is projected to decrease or grow more slowly, and the "P" (price) doesn't adjust downward as quickly, the P/E ratio could rise in the short term.

• Cost of Capital: As interest rates rise, the cost of borrowing increases. This increased cost can impact a company's bottom line by reducing profits, leading to lower earnings per share. If the stock price remains constant while earnings fall, the P/E ratio will increase.

• Investor Risk Appetite: Higher interest rates often make fixed income investments more attractive compared to riskier assets like stocks. As a result, investors might sell stocks and buy bonds instead, leading to downward pressure on stock prices. If stock prices decrease more than earnings, the P/E ratio would fall.

• Economic Outlook: High interest rates are often a response by central banks to inflationary pressures or overheated economic growth. However, if rates continue to rise, it might be a signal of a slowing economy in the future. In such a case, anticipated earnings might decline, which could lead to a lower P/E ratio if stock prices adjust downward accordingly.

Remember, there's no simple, direct relationship between interest rates and P/E ratios. Many other factors influence both stock prices and earnings, including a company's financial health and growth prospects, industry trends, and the overall economic environment. While rising interest rates can potentially lower P/E ratios, they're just one piece of a larger puzzle. It's always important to consider a range of factors when assessing investment decisions.