How Higher Interest Rates Impact Growth Stock Valuations

Growth stocks, by definition, derive their value primarily from anticipated future earnings, often far into the future. Higher interest rates can significantly impact the valuation of these stocks due to the following reasons:  

1. Discounted Cash Flow (DCF) Model:

• Discount Rate: The DCF model is a common valuation method for growth stocks. It discounts future cash flows to their present value. A higher interest rate increases the discount rate, reducing the present value of future cash flows. This leads to a lower valuation for the company.  

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• Time Value of Money: The core principle of the DCF model is that money today is worth more than money tomorrow. Higher interest rates magnify this effect, making future earnings less valuable in today's terms.  

2. Investor Preference Shift:

• Bond Yields: As interest rates rise, the yield on bonds increases. Bonds become more attractive to investors seeking safer, fixed-income returns.  

• Risk Appetite: This shift in preference can lead to a decrease in investor appetite for riskier growth stocks. Investors might prefer the stability and guaranteed returns of bonds over the uncertain future earnings of growth stocks.  

3. Cost of Capital:

• Debt Financing: Higher interest rates increase the cost of borrowing for companies, including growth companies that often rely on debt to fund their expansion. This can reduce profitability and growth potential.  

• Equity Financing: Even if a company doesn't use debt, the increased cost of capital for other companies in the market can impact investor expectations and valuation multiples.

4. Economic Outlook:

• Growth Expectations: Rising interest rates often signal a tightening monetary policy, which can indicate concerns about economic growth. This can dampen investor optimism about the future prospects of growth companies.  

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In essence, higher interest rates make the future less valuable in today's terms, which directly impacts the valuation of growth stocks that rely heavily on future earnings for their worth.

References:

• 1. Growth Stock: What It Is, Examples, vs. Value Stock - Investopedia

• 1. What is Discounted Cash Flow (DCF)? Formula and Examples - Tipalti

• 2. What Is Present Value? Formula and Calculation - Investopedia

• 3. The Impact of Interest Rates on Valuation and Estate Planning - Blue & Co., LLC

• 1. Discounted Cash Flow (DCF) Valuation: The Basics - Forage

• www.theforage.com

• 1. How Changing Interest Rates Impact the Bond Market - U.S. Bank

• 2. How Rising Interest Rates and Stock Valuations Are Linked - TEXPERS

• 1. The Effect of an Interest Rate Hike - First Business Bank

• 2. How Do Interest Rates Affect the Stock Market? - Investopedia

• 1. Why are Growth Stocks Impacted by Rising Interest Rates? - Bookmap