In India, the reserve bank of India based on its monetary policy can increase or decrease the repo rate. Sometimes they keep the repo rate constant. Repo rate is the interest rate at which RBI lend short term funds to Banks. Similarly, global central banks increases or decreases the interest rates that they charge on banks to access money.
While deciding to increase or decrease interest rates, these central banks always try to strike a balance between growth and inflation.
Valuation of a company depends on the company’s future cash flow. Investors discount these cash flows based on the weighted average cost of capital to bring it to the present value to arrive at an indicative price for the stock. Weighted average cost of capital is the combination of cost of equity and cost of debt. With the increase in interest rates, cost of debt will go up resulting depress valuation of equities.
If equity valuation is lower compare to the present market price, then investors will start selling stocks.
Impact of increase in interest rates on company’s share price
Interest rates are the cost of using someone else’s money. When public or corporate takes loan from bank, they need to consider the interest rate first as it’s the extra money that they have to pay for using the funds. Based on the income of the business or consumer, they will decide whether the cost of debt is higher or lower for them. Due to this reason, business and consumers will start spending less and try to save more by investing in fixed deposits or government securities.
With the increase of interest rates, debt becomes costly. Companies with high interest coverage ratios will have less impact on the profitability than the low interest coverage ratio. These higher costs can be passed on to the consumer. However, consumers will avoid luxury items as they will become costly due to high cost of debts. Due to this reason, investors will not buy stocks of high debt companies to their portfolio.
Raising interest rates makes money more expensive and reduce the money supply to market. Fresh borrowing will be available at a higher cost. Therefore, business will borrow less and spend less, which will resulted in less revenue and profit. Therefore, lower corporate profit will result in lower stock prices.
If RBI increase interest rate, then borrowing costs will go up. If corporations can’t borrow easily, they can’t grow, as a result economy will slow down.
Due to all these factors, rising interest rates affect investor’s psychology. When it goes up, investors think that consumers will spend less resulting less earnings for companies and therefore stock prices to drop. This means, higher the interest rates, lower the equity valuation.
Impact of decrease in repo rates on company’s share price
Lowering interest rates makes money cheaper and increase the money supply to market. Therefore, spending increases, financial health improved and as a result revenue and profit increases. When rates are low, company can borrow funds easily. Therefore, company can easily get more money to invest in business and consumer gets more money to spent.
When central bank cut interest rates, consumer and business spending goes up and as a result share price to rise with expectation of high revenue and earnings.
Due to increase in spending, seller tend to increase selling price leading to inflation. To keep the growth and inflation in balance, central bank has to carefully set the interest rates.
The key RBI rates that investor are tracking are as follows;
- Repo rate
- Reverse repo rate
- Cash reserve ratio – CRR
Relationship between stock price movements and interest rate is fairly indirect as they move in opposite direction. However, there is no guarantee that the market movement will always be indirect. If market has already factored a rate hike or rate cut, then it will not react to the decision of the central bank.