Interest Rate Sensitivity of Growth Stocks

Updated: Jul 12, 2021

I'm writing this article on March 6, 2021. There has been a noticeable rise in interest rates lately, the 10 year US treasury climbed from around .55% in July

to 1.56% today.

In general, growth stock valuations are most affected by changing interest rates. This is a consequence of the time value of money (and other things too). Growth stocks that will generate little or no FCF now and most or all in the future are discounted over more periods to arrive at their valuation.

For example, if you were to ask an EV startup investor when they expected the company to start generating a lot of free cash flow they would probably tell you it was some years out. Alternatively, if you were to ask an investor in Coca-Cola r they probably say they expect consistent free cash flow every year.

Let's look at the FCF of Company A and Company B.

Company A produces an even $100 every year. Company B does not generate any free cash flow for the next 8 years but then in the last two years, it generates $1000 of free cash flow each year.

Company A is like Coke which generates consistent free cash flow. Company B is more like a growth stock that generates cash further out in the future, but not now.

Let's find the present value of the FCF for each company.

Company A PV = $702.36 @ 7%

Company B PV = $1052.28 @ 7%

Next, we raise the discount rate to 10%.

Company A PV = $614.46 @ 10%

Company B PV = 809.64 @ 10%

In order to figure out which was more sensitive to interest rates, we need to compare the price changes on a percentage basis.

Therefore, as a rule of thumb we can assume that all else being equal, the PV of cash received at a later date is more sensitive to changes in the discount rate.

Why does a rise in treasury yields increase the discount rate applied to a companies cash flows?

At first glance it makes no sense that the discount rate applied to a company should be tied to the yield of a treasury. After all, these two things seem worlds apart. The issue is the opportunity cost of capital. Each time we make an investment we have decided to forego purchasing a bond to buy a stock.

How do we make that decision?

Investors demand a premium to pruchase a growth stock instead of a much safer treasury. The difference between the expected return of the treasury and the stock must be a premium which adequately compensates the investor for this excess risk. All else being equal, if treasury rates rise and the investor buys shares at the same price they are accepting less premium for their risk. If an investor wants to hold the risk premium cosntant when treasury rates rise then the discount rate for the equity investment must rise and the price paid must be less.

We can see the relationship between the risk free rate and cost of equity by looking at the capital asset pricing model (CAPM).

Cost of Equity = Risk Free Rate + Beta * Equity Risk Premium

As you can see, if the equity risk premium remains constant a 1% increase in the risk-free rate will result in a 1% increase in the cost of equity.

To summarize, growth companies are generally more sensitive to interest rate changes because the bulk of free cash flow is expected at a later date and is discounted over more periods. As a result, when interest rates and the cost of equity rise, growth company valuations may be most affected.