How Interest Rates Feed Into Equity Valuation

A rate change reaches a company by three routes: what it pays on its own borrowing, what its customers can afford to borrow, and what a holder of the company requires to hold it rather than something else. The first two land in the company's own numbers and this guide computes them. The third is a valuation question, covered where valuation is covered.

Four things underneath that answer were built earlier. A policy rateThe rate a central bank charges when it lends to banks itself. Most other rates in an economy are quoted against it. How it gets decided, and by whom, is covered where monetary policy is covered., who decides it and how it moves, is settled where monetary policy is covered. The transmission lagThe gap in time between a policy rate changing and the rates households and companies actually pay changing. The gap is neither instant nor the same for everybody. between that rate changing and a borrower paying something different is settled there too. Why lending can expand or shrink without the rate on it having moved at all is settled where money and credit are covered. A macro variable reaches a company through a small number of named routes, and profit is a thin residual of two large numbers. Both were set out where transmission itself was introduced. Below, the rate is walked along each route in turn, with the arithmetic printed where arithmetic is possible and the boundary named where it is not.

Every rupee figure below belongs to Nirvi Engineering and Ojaswi Cements, two invented companies inside the invented Republic of Sankhya.

By what routes does a rate change reach a company?

The three routes are easier to feel in a household than in a set of accounts. Start there. Suppose the rate on borrowing in a small town goes up. Three separate things happen to a shopkeeper there, and they are genuinely different things. The first is that the shopkeeper's own home loan instalment gets bigger. The new instalment can be worked out on paper the same evening. The second is that the person who was going to buy the shopkeeper's second hand scooter on credit now finds the loan dearer and therefore offers less or walks away. Nobody knows how many of those buyers were borrowing, and no number can be put on the route without that. The third is that the fixed deposit down the road now pays more, so anybody deciding whether to lend money for the shop wants more than they did last month. The third one changed nothing about the shop.

A company meets exactly those three, and the useful move is to mark each one as computable or not before following any of them. Route one is what Nirvi Engineering pays on its own borrowing, and that is arithmetic on a debt figure and a rate, so it is computed here in rupees. Route two is what Nirvi Engineering's customers can afford to borrow. The direction of that is clear and the size is not, so route two gets a direction and no figure. Route three is what a holder of Nirvi Engineering requires for holding it rather than something else. Route three leans in a direction that can be named, and sizing it needs the machinery of valuation, covered as a subject in its own right.

What does a fifty basis point rise cost Nirvi Engineering on its own borrowing?

Take Nirvi Engineering's three published lines: Rs 1,000 crore of revenue, Rs 900 crore of costs, and therefore operating profitThe figure a company has left once its running costs come out of revenue, and before anything at all is paid to lenders or to the tax authority. Most macro variables land in this line before they land anywhere else. of Rs 100 crore. The company carries one borrowing and one only: Rs 200 crore of debt at 9.00 per cent. Multiply and the interest is Rs 18 crore a year. Now let the rate rise by fifty basis pointsOne basis point is one hundredth of one per cent, so fifty of them is half a percentage point. A quarter of a per cent said aloud is easy to mishear, so rates are quoted this way instead., which takes the rate on that debt to 9.50 per cent. Multiply again and the interest is Rs 19 crore. The whole of the effect on route one is that one extra crore of rupees.

Now put that crore somewhere it can be judged. Against Rs 100 crore of operating profit it is 1.00 per cent. One per cent is small, and it is a fact about Nirvi Engineering rather than a fact about the rate. The rate move was the same fifty basis points it would have been for anybody. The size of the debt sitting underneath turned that move into one per cent of profit rather than four or ten, and nothing else did. An account that reports the rate move and stops has reported the half of the calculation that is the same for every company in Sankhya, and left out the half that differs.

Two honest qualifications belong here rather than in a footnote. First, a rate change reaches a borrowing only where the borrowing lets it. A floating rateA rate on a borrowing that resets from time to time against some reference. A fixed rate does not reset. The same policy move therefore reaches one borrower immediately and another not for years. resets and a fixed one does not, so the same fifty points can land on Nirvi Engineering this quarter and on the company next door only when its borrowing is refinancedReplacing an existing borrowing with a fresh one, usually because the old has run its term. Refinancing is the moment a rate agreed years ago is finally replaced by whatever today's rate is.. Second, interest sits below operating profit, so the Rs 1 crore does not touch the Rs 100 crore at all. The Rs 1 crore comes out of what is left below that line. The same Rs 1 crore is a larger share of what survives interest than of what precedes it, so which profit is meant has to be stated whenever a share is quoted.

Why does the same rise cost Ojaswi Cements four times as much?

Put a second invented company beside the first and hold everything constant except the borrowing. Ojaswi Cements matches Nirvi Engineering line for line everywhere above the debt: Rs 1,000 crore of revenue, Rs 900 crore of costs, Rs 100 crore of operating profit. The one difference is that Ojaswi Cements carries Rs 800 crore of debt rather than Rs 200 crore, at the same 9.00 per cent. Its interest is therefore Rs 72 crore rather than Rs 18 crore. Send the same fifty basis points through and the rate becomes 9.50 per cent, the interest becomes Rs 76 crore, and the rise is Rs 4 crore. Against the same Rs 100 crore of operating profit that is 4.00 per cent.

Four times the debt, four times the share of profit, from a rate move that was identical in both companies. That relation is a tight one: the ratio of the two shares, 4.00 against 1.00, is exactly the ratio of the two debt figures, Rs 800 crore against Rs 200 crore. Nothing else in the arithmetic can move it. The sentence people reach for, that higher rates hurt companies, turns out on inspection not to be a claim about rates at all. The claim is really about how much a particular company has borrowed, wearing a macro coat.

The other half of the comparison shows how differently the two companies wear the same event, so it is worth printing too. Take the interest out of the operating profit in each case. Nirvi Engineering keeps Rs 82 crore after interest and the rise takes it to Rs 81 crore. Ojaswi Cements keeps Rs 28 crore and the rise takes it to Rs 24 crore. The same fifty basis points that shaved a rounding error off one company took a seventh off what the other one had left. Every figure in that sentence is printed here, so the arithmetic can be redone.

What happens on the route through the company's customers?

Route two is the one people skip, and it is often larger than route one. Consider a shop selling refrigerators on twelve month instalments. When the rate on those instalments goes up, the monthly payment on the same refrigerator goes up with it, and some customers who were within reach of that payment last month are outside it this month. Nothing about the refrigerator changed. Nothing about the shop changed. The set of people who can afford the refrigerator got smaller. The thinning of that set is the whole route, and it can be seen without any arithmetic at all.

Nirvi Engineering meets the same thing at its own scale. If the buyers of what it sells borrow to buy, then dearer borrowing thins the queue, and thinner demand shows up in revenue. The direction is clear enough to state without hedging. The size depends on how much of Nirvi Engineering's demand is bought on credit, and that share has never been stated, so no figure for the size can be produced. That is a genuinely missing input, and filling it with a plausible share would produce a number nobody had checked.

There is a second reason to be careful here, and it was built where money and credit are covered rather than here. Credit growthThe rate at which lending in an economy is expanding. The rate charged on it is not the only thing credit growth answers to. Lending can slow while rates are falling and expand while they are rising. answers to more than the rate charged on it. Lenders can tighten who they will lend to while the rate is falling, and they can loosen while it is rising. So even if the share of Nirvi Engineering's demand running on credit were known exactly, the rate alone would not settle what happened to that credit. Two unknowns sit on this route rather than one, and a route with two unknowns gets a direction rather than a figure.

Which of the three routes touch the company's own numbers?

The split between the first two routes and the third is the pivot of the whole subject. Routes one and two both land inside Nirvi Engineering's own statement of what it earned. Route one lands in the interest line: Rs 18 crore became Rs 19 crore, and that is a line item anybody could point at. Route two lands in revenue, and revenue then runs down through costs to what is left. Both of them change the number at the bottom. Nirvi Engineering's figures written out before the rate moved and again afterwards would differ.

Route three does not appear on that sheet anywhere, at any point, under any heading. Nothing a holder requires enters revenue, enters costs, enters interest or enters what is left. The company's figures before and after a change in what holders require are identical, line for line. The identity of those two sheets is not a subtlety but the single most useful fact in the subject, and everything below rests on it.

What does a holder of Nirvi Engineering require when rates change?

The direction can be stated plainly and then left alone. When the safer places to put money start paying more, the comparison facing anybody holding something less safe has improved, so they want more from it too. When the safer places pay less, the comparison goes the other way. Those two sentences are the whole of route three in words, and the relationship is a real one rather than a hedge.

The consequence is also a direction. If a holder requires more from the same expected earnings, then the same expected earnings are worth less to that holder, and if a holder requires less, they are worth more. The direction is as far as words alone can carry route three. Turning it into a figure for what a holder requires, and from there into a figure for what the earnings are worth, takes machinery that somebody has to choose and defend. The required returnWhat somebody wants for parting with money for a period, given what else they could have done with it instead. Estimating it, and what happens to the estimate afterwards, is covered where valuation is covered. and everything built on it belong to valuation, which is covered as a subject in its own right.

Why is the direction easier to state than the size?

Because a direction needs one fact and a size needs several. To say which way route one pushes, it is enough to know that Nirvi Engineering borrows and that the rate on its borrowing went up. To say by how much, five things are needed: the debt figure, the rate, whether the rate resets, when it resets, and the base the answer is measured against. All five are printed above for route one, and that is exactly why route one gets rupees.

Route two has the direction fact and is missing two of the size facts, so it gets a direction and stops. Route three has the direction fact and is missing the entire apparatus that would turn it into a size. The gap there is not one missing number but a set of choices somebody has to make deliberately. The pattern is worth carrying away: the number of routes that can be stated is almost always larger than the number that can be measured, and pretending otherwise is where a chain of reasoning quietly turns into a guess. Saying so out loud is more useful to a reader than a complete looking answer with an invented input inside it.

What separates a rate reaching earnings from a rate reaching what earnings are worth?

Conflating the two is the commonest error in this whole subject. Take them apart and hold them side by side. Routes one and two change Nirvi Engineering's earnings. Interest climbs to Rs 19 crore from Rs 18 crore, so what survives interest drops to Rs 81 crore from Rs 82 crore, and if route two is running as well, revenue moves too. Both are real changes to real lines and they can be added up.

Route three changes what those earnings are worth to somebody holding them, and it does this without touching the earnings at all. Hold Nirvi Engineering's figures completely fixed. Same Rs 1,000 crore of revenue, same Rs 900 crore of costs, same Rs 100 crore of operating profit, same Rs 18 crore of interest, same Rs 82 crore left afterwards. Now let what a holder requires move. Every one of those figures is unchanged and something else has moved. Two different things travel by two different routes and only one of them is arithmetic. So the question to ask of any claim about rates and equities is whether it is about the earnings or about what the earnings are worth.

Why does the chain stop short of a valuation?

Valuation is a subject in itself, and its difficulty does not lie in the arithmetic. The arithmetic is the easy part. The hard part, and the part that takes real time to learn, is the set of choices that go in before any arithmetic starts: which earnings are being valued, how long they are taken to last, by what method a future figure is brought back to a figure for today, and which alternative the whole thing is measured against. Every one of those is a decision, and every one of them can be made badly.

Handing over a formula without the choices behind it does harm rather than none. A reader who takes a formula on trust gets an answer that looks precise and rests on four assumptions they never saw. The precision is the dangerous part, and the precision is what makes the answer feel checked. Better to leave the reader with a direction they can state confidently, a chain they can compute where it is computable, and a clear signpost to where the rest is taught properly.

What would a reader need in order to go further?

Four of them, and it matters a great deal that they arrive as questions and not as a formula. The first is which earnings. The word covers several different quantities and they are not interchangeable: operating profit was Rs 100 crore, what was left after interest was Rs 82 crore, and cash actually collected is a third thing again. Picking one is a decision. The second is over what period. A figure for one year and a claim about many years are different claims, and only the second needs a view about how long anything lasts.

The third is by what method a future figure is brought back to a figure for today, and the fourth is which alternative use of the money the whole thing is being measured against. Each of those four is a choice somebody makes and can defend or fail to defend, and four such choices are why valuation is taught as a subject rather than handed over as a line of algebra. They are covered where valuation is covered, and a reader arriving there should expect to spend time on the choices rather than on the multiplication. Before all four come the three routes, named and marked, with rupees where rupees are possible.

How does a lender, an analyst or a household read the same rate move?

The same fifty basis points land in three different working days. A lender looking at Ojaswi Cements is on route one and nowhere else, and the question is a coverage question: operating profit of Rs 100 crore against an interest bill that has just gone from Rs 72 crore to Rs 76 crore, leaving Rs 24 crore rather than Rs 28 crore. The coverage question is answerable in rupees tonight, from figures the company publishes, and that is why lending decisions turn on debt loads rather than on rate forecasts.

An equity analyst is on routes one and two together, and the working question is an attribution question: of everything that moved in these numbers, how much was the rate and how much was everything else. Route one is separable because it is arithmetic. Route two is not fully separable, so an honest note says so rather than assigning it a share. A household is on route one as well, running exactly the same multiplication on a home loan balance rather than a corporate debt figure. The arithmetic is therefore worth learning even by somebody who will never open a company's accounts. Balance times rate, measured against the income it has to come out of, and the answer changes with the balance rather than with the news.