How interest rates hit growth vs value

A stock is a claim on future cash flows, and the value of anything in the future depends on the interest rate you use to bring it back to the present. That single fact explains why rising rates hurt some stocks far more than others, and why a trader who ignores the rate backdrop can be right about a company and wrong about its stock for a year.

Discounting in one table

Suppose a business will produce $100 of cash in a year. How much is that worth today? It depends on what you could earn elsewhere with no risk.

Read across the bottom row. A dollar twenty years out is worth $67 at 2% rates and $31 at 6%: rates tripling more than halves it. Now read the first column: the same rate change takes a dollar one year out from $98 to $94, a 4% haircut.

Distant cash flows are far more sensitive to rates than near ones. That is the whole mechanism.

Growth vs value

A "growth" stock is one whose cash flows are mostly in the future: it is reinvesting everything now to be much larger later. A "value" stock is one whose cash flows are mostly now: it is paying dividends and buying back shares from profits it already makes. In bond language, growth stocks are long duration and value stocks are short duration.

Apply the table. When rates rise from 2% to 6%, the value stock's near-term cash is marked down a few percent; the growth stock's distant cash is marked down by half. That is why, in a rising-rate environment, high-multiple growth stocks can fall 50% while their businesses grow exactly as planned. The earnings did not change; the rate at which they were discounted did.

A simplified illustration with two companies, each expected to produce $1,000M of total cash over the next twenty years:

Same total cash. The company whose cash comes later loses more of its value from the same rate move. (The figures are computed by discounting each year's cash at the rate and summing; the exact numbers matter less than the gap between the two changes.)

Key idea: Rising rates cut the present value of distant cash flows most. Growth stocks are mostly distant cash flows, so they fall hardest when rates rise and rally hardest when rates fall.

The multiple is the mirror image

Another way to see the same thing: the P/E multiple is roughly the inverse of the rate the market demands. If investors require an earnings yield of 5%, they pay 20 times. If they require 7%, they pay about 14 times.

ACME at $40 with $2.10 of EPS has a 5.3% earnings yield. If ten-year Treasury yields rise from 2% to 4.5%, the extra return investors demand from stocks over bonds does not vanish, so the required earnings yield rises too, say to 7%. At 7%, ACME's fair P/E is about 14, and the price on $2.10 of EPS is roughly $30. A 25% decline with no change in the business.

For a growth stock at 40 times earnings (a 2.5% earnings yield, justified by expected growth), the same shift in required return does proportionally more damage, because a larger share of its value was the growth that rates now discount more heavily.

What a trader watches

You do not need to forecast rates. You need to know which regime you are in and what it does to the stocks you trade.

• The ten-year Treasury yield. The benchmark for discounting. Its direction over the last three months matters more than its level.
• The two-year yield. Tracks expected central-bank policy. When it rises fast, the market expects tightening.
• Central-bank meeting dates. Scheduled; on the calendar; a macro version of earnings day. Many traders reduce size into them.
• Growth vs value relative performance. A chart of a growth index divided by a value index shows the regime directly. When the ratio is falling, growth is being sold; fighting that with individual growth longs is trading against the tide.

Regimes in practice

Tables like this are tendencies, not rules. Their use for a trader is as a filter (module 1): in a rising-rate regime, a breakout in an unprofitable, high-multiple growth stock is fighting the discount rate, and it needs a stronger setup and a smaller size than the same breakout in a rate-neutral stock.

ACME in a rate shock

ACME is a profitable industrial at 16.7 times forward earnings with 1.6 times debt/EBITDA and fixed-rate debt for three years. Rates rise two points. Effects:

1. Multiple compression. The sector's forward P/E slips from 17 to 14. ACME at $2.52 of forward EPS moves from $42 to $35 with no change in the business.
2. Interest cost. None until the debt reprices in three years; coverage stays at 10 times. Good.
3. Demand. Industrial customers borrow to buy equipment; some orders slip. Estimates may edge down.
4. Relative position. ACME loses less than a 40-times software stock and more than a bank. Within its sector, its low debt is an advantage.

None of this makes ACME a sell on its own. It makes the backdrop a headwind, which changes the bar for any long trade and the size it deserves.

Try it: Pull a five-year chart of the ten-year Treasury yield and, beneath it, a chart of a growth index divided by a value index. Mark the periods where yields rose sharply. Note what the ratio did in each. Then pick one high-multiple stock you follow and see what its P/E did over the same windows.

Recap

• Value today of future cash falls as rates rise, and distant cash falls most.
• Growth stocks are mostly distant cash flows (long duration); value stocks are mostly near cash flows (short duration).
• The P/E is roughly the inverse of the required earnings yield; higher rates mean lower multiples with no change in earnings.
• Watch the ten-year and two-year yields, central-bank dates, and the growth/value ratio to know the regime.
• Use the regime as a filter: high-multiple longs in a rising-rate regime need a better setup and a smaller size.