Monday, August 3, 2015

Curb Your Enthusiasm: The Valuation Impact of Interest Rate Increases

Banks are suffering from low net interest margins (NIM) and net income growth since the 2008 Great Recession. Some believe the Federal Reserve’s low interest rate policy is responsible for this situation. In fact, the two favorite excuses provided by banks for performance issues are regulation and low rates. This post focuses on the bogus interest rate excuse. Bankers are awaiting the long expected Fed rate hike now hoped for this fall. They believe NIM, net income and hopefully stock prices will benefit from the hike. NIM and net income may initially and temporarily improve but bank stock prices are unlikely to improve.

All intrinsic valuation models capitalize expected future earnings or cash flows and their timing at a discount rate. The rate reflects two factors. The first is the time value of money (i.e. present value factor) usually represented by the risk free (Rf) rate of return. The second factor is the riskiness of the cash flows. Keeping risk, earnings and the timing of the earnings constant, rate increases will impact the time value of money thru changes in Rf. Simply stated expected earnings discounted at a higher rate have a lower (present) value.

It gets a little more complicated for banks because there may be an initial temporary increase in bank earnings when rates rise. This depends on the shape of the yield curve and how the bank’s balance sheet is positioned (asset sensitivity). Over time, the liabilities will re price and the benefit disappears.

All other things equal, rate increase are not good for stocks, banks included. Simple valuation fundamentals may be forgotten, but do not disappear.


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