How Interest Rates and Inflation Influence Stock Valuation

Ravi sat in his study, scrolling through the latest economic news, wondering why the markets reacted sharply to the Reserve Bank of India's (RBI) decision on interest rates. He realised it was time to deepen his understanding of how interest rates and inflation play vital roles in stock valuation. Let’s explore how these economic indicators work and their significance for stock valuation.

Interest Rates

Interest rates represent the cost of borrowing money, primarily set by central banks—in India’s case, the RBI. The RBI influences interest rates through its policy rates, such as the repo rate, which determines the rate at which banks borrow from the RBI. Changes in interest rates signal economic activity, influencing spending, saving, borrowing, and ultimately, investments in stocks.

When interest rates change, it impacts not just loan repayments and savings returns but also investor sentiment, affecting stock prices.

Impact of Rising Interest Rates

• Increased Borrowing Costs: When interest rates rise, borrowing becomes more expensive. Companies reliant on loans to expand or sustain operations face higher costs, which can reduce profitability.
• Reduced Future Cash Flows: For investors like Ravi, higher borrowing costs make future cash flows from companies less attractive. As financing becomes pricier, the valuation of growth stocks—especially those linked to future earnings—tends to decline. Investors often shift their focus toward sectors less dependent on borrowing, such as banking and financial services.
• Alternative Investments Become Attractive: Higher interest rates make fixed-income securities like bonds more appealing, prompting some investors to shift funds from stocks to these safer assets.

Impact of Falling Interest Rates

• Cheaper Borrowing: Conversely, falling interest rates make borrowing cheaper. Companies can finance projects at a lower cost, which can boost profits and, in turn, stock prices.
• Shift Towards Equities: Low interest rates mean lower returns from savings instruments, encouraging investors to move into higher-risk assets like equities. For instance, during the COVID-19 pandemic, the RBI slashed interest rates to stimulate the economy, leading to increased consumer spending and stock price rises in sectors like consumer goods and real estate.

Inflation

Inflation refers to the rate at which the general level of prices for goods and services rises, eroding purchasing power. The Consumer Price Index (CPI) is a common measure of inflation in India and affects both consumers and businesses, significantly impacting stock valuation.

Impact of Inflation on Stocks

• Rising Costs: High inflation increases the costs of raw materials and labour for businesses. Companies that cannot pass these costs onto consumers may see their profit margins shrink, negatively impacting stock valuation. For example, FMCG companies like Hindustan Unilever Ltd. (HUL) may struggle to maintain margins if inflation raises raw material costs and they cannot proportionally increase prices due to consumer resistance.
• Higher Interest Rates: High inflation often leads the RBI to raise interest rates to control it. As mentioned earlier, higher rates can dampen business expansion and consumer spending, creating a double impact on stock prices.
• Moderate Inflation: On the other hand, moderate inflation can indicate a growing economy. Companies can raise prices without losing customers, leading to higher revenues and better stock performance.

Real vs. Nominal Interest Rates

Understanding the difference between nominal and real interest rates is essential for grasping the interplay between interest rates and inflation.

• Nominal Rate: The stated interest rate without adjustment for inflation.
• Real Interest Rate: Accounts for inflation, calculated as Nominal Interest Rate - Inflation Rate.

For instance, if the nominal interest rate is 6% and inflation is 4%, the real interest rate is 2%. Real interest rates matter because they reflect the true cost of borrowing and actual returns on investments. When real rates are low or negative, it encourages borrowing and investing in riskier assets like stocks, driving stock prices up.

Conclusion

Interest rates and inflation are key economic indicators that significantly influence stock valuation. Interest rates affect borrowing costs, investment attractiveness, and profitability, while inflation impacts input costs, consumer demand, and business margins. By understanding how these factors affect various sectors and stock prices, investors like Ravi can make informed decisions, optimising their investment strategies for risk and returns.

As we conclude this chapter, you are now equipped to understand the broader economic environment's influence on investments. In the next chapter, we will explore how GDP influences stock analysis and why understanding this macroeconomic factor is crucial for making sound investment choices.