How We Think

Impact Of Interest Rates On Profitability and Valuation

Higher interest rates have dominated market discussions so far this year, and for good reason.  The U.S. 10-Year Treasury note yield has continued its relentless ascent from less than 1.5% at the end of 2021 to nearly 4.8% at quarter-end, which is the highest level since 2007.  While interest rates are often compared to “gravity” [1] for asset prices, many of today’s largest asset classes do not appear to be suffering from higher rates.  Despite a modest correction over the last two months, the S&P 500 Index still trades at a price-to-earnings (P/E) ratio [2] of more than 21x.  Additionally, U.S. housing prices are increasing again to all-time highs. Today’s prices do not feel like they are under pressure from extra “gravity”. Higher interest rates reduce the value of financial assets and make cash a more attractive alternative.  Changing interest rates impact the discount rate that investors use to value future cash flows[3].  The further in the future the cash flows of a financial asset, the greater the impact of the change in interest rates[4].  Companies that currently generate substantial free cash flow[5] and trade at low multiples of these cash flows should outperform the broader market in a rising interest rate environment like today because their duration[6] is effectively shorter.  Rising interest rates also impact the equity value of companies with leverage because higher interest expenses reduce earnings available to shareholders when the company’s debt is refinanced.

Below we illustrate how changing interest rates impact the income statement and intrinsic value of a hypothetical company.  This company grows revenue by 5%, generates a healthy 13% operating margin, and has a moderate amount of financial leverage with total debt of two and a half times its earnings before interest and taxes (EBIT)[7].  These metrics are comparable to the S&P 500 Index as a whole[8]. The income statements show the hypothetical company’s financial results in response to a 5-percentage point increase in borrowing costs, which is what many BBB-rated companies are seeing today.  If the hypothetical company’s debt has a floating rate, it will feel a higher interest expense immediately.  On the other hand, a company with fixed-rate debt with a seven-year maturity will only feel the higher interest expense when it refinances the debt.  The implication of higher interest expenses to the cash flows available to shareholders — and thus any calculation of intrinsic value — is meaningful for companies with both types of debt.

Of course, it makes sense that the greater the degree of current leverage, the greater the impact of the increase in interest rates will have on a company. Additionally, a recent law change disproportionately impacts companies with high financial leverage.  The Tax Cuts and Jobs Act of 2017 introduced a cap on the interest tax deductibility shield at 30% of adjusted taxable income, which means that interest expenses more than 30% of taxable income cannot be deducted for tax purposes.  For example, if the hypothetical company above has a higher debt burden of eight times its EBIT with a seven-year maturity, the impact of a 5-percentage point increase in borrowing rates will reduce its cash flows to equity over the next twenty years by 17%.  In the table below, we show the decrease in cumulative cash flow for our hypothetical business from above but with varying levels of leverage. We have included the debt-to-earnings before interest, taxes, depreciation, and amortization (EBITDA)[9] ratio for context because it is Wall Street’s preferred metric of measuring financial leverage despite the important flaw that it ignores depreciation, which is a real expense for all companies.

The rapid rise in interest rates we have seen over the last two years has had a negative impact on the profitability of companies with high leverage and upcoming debt maturities.  Public markets have done a decent job of penalizing such companies, which is a large reason why U.S. small capitalization companies, which on average have higher leverage, have underperformed the S&P 500 Index[10]. Private markets, on the other hand, do not appear to have fully accepted the reality that highly leveraged companies are worth materially less in today’s environment.

The impact of higher interest rates on the intrinsic value of a business is greater than just the decrease in cumulative cash flow over twenty years.  With a higher opportunity cost available to the investor (e.g. higher yielding U.S. Treasury notes), a higher discount rate should be used to value the business. The final table below shows the impact of combining a higher discount rate and higher interest expense on a hypothetical company’s intrinsic value. Markets have certainly not priced in a 5-percentage point increase in the discount rate.  Thus, the spread between the S&P 500 Index earnings yield and the 10-Year U.S. Treasury note yield is the smallest in more than twenty years.

Considering the effect of a rapid change in interest rates has always been a part of our process.  We apply this refinancing framework to all current and prospective investments.  Our portfolio today remains unlevered with minimal refinancing risk – our weighted average net-debt-to-EBIT is a mere 0.3x. Despite this, our portfolio of high quality and growing businesses continues to trade at a discount to the market.

Source: Bloomberg [11]

We have a cautious outlook in the current interest rate environment.  We are seeing data that suggest consumers in the bottom half of the economic spectrum are under considerable pressure.  The moratorium on federal student loan interest and repayment recently expired, which impacts almost 44 million Americans with $1.6 trillion of outstanding federal student loans and should be a drag on consumption )[12]. The U.S. corporate sector is exposed to refinancing more than $5 trillion of debt through 2028 which could weigh on corporate profits.  Meanwhile, the U.S. government is also refinancing its debt.  The average maturity is only about six years, so a rapid increase in federal interest expense exacerbating the federal budget deficit is inevitable. We expect a balanced budget initiative to reemerge as a political issue over the next few election cycles.  Neither our economy nor markets have dealt with a rising interest rate environment in more than forty years, and the cascading effects have likely not fully played out.  We are wary of our ability to forecast future outcomes in credit-sensitive parts of the economy, but we believe our portfolio of businesses will continue to grow profits significantly in the coming year.

 

 

 

 

 

 

 

 

[1] https://www.youtube.com/watch?v=W4AIul7_9o8

[2] Price-to-earnings ratio is the measure of the share price relative to the annual net income earned by a company, per share.

[3] Cash flow is the amount of cash that comes in and goes out of a company.

[4] https://www.cookandbynum.com/how-we-think/inflation/

[5] Free cash flow is the amount by which a business’s operating cash flow exceeds its working capital needs and expenditures on fixed assets.

[6] Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates.

[7] Earnings before interest and taxes (EBIT) is operating earnings, operating profit, and profit before interest and taxes.

[8] Bloomberg, Julius Baer, Goldman Sachs

[9] The debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio measures financial leverage and a company’s ability to pay off its debt.

[10] https://www.ft.com/content/e68965ca-249a-4761-badf-1c5b2da9bb94

[11] The Standard and Poor’s 500 (S&P 500), is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.

The MSCI All Country World Index (MSCI ACWI) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The index consists of 49 country indexes comprising 23 developed and 26 emerging market country indexes.

The Standard and Poor’s SmallCap 600 Index is a stock market index established by S&P Global Ratings. It covers roughly the small-cap range of American stocks, using a capitalization-weighted index. To be included in the index, a stock must have a total market capitalization that ranges from $850 million to $5.2 billion.

The MSCI Emerging Markets Index captures large and mid cap representation across 24 Emerging Markets (EM) countries. With 1,377 constituents, the index covers approximately 85%of the free float-adjusted market capitalization in each country.

The MSCI ACWI excluding US Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries (excluding the US) and 24 Emerging Markets (EM) countries. With 2,322 constituents, the index covers approximately 85% of the global equity opportunity set outside the US.

[12] https://educationdata.org/student-loan-debt-statistics