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Why Interest Rates Matter

Why should I care about interest rates?  Well, the level of prevailing interest rates plays a very significant role in determining enterprise valuation.

 

How Interest Rates Impact Valuation

The valuation of a business enterprise is determined largely by asking a simply question, "What is the present value of the sum of all of the periodic net cash flows I expect this enterprise to generate in the future?"  We can unpack this question in detail but, to keep it short, valuations are typically spoken of in simplified terms. Typically, once hears about "enterprise valuation multiples" and about "EBITDA," a measurement of periodic (typically, annual) enterprise cash flow. Using this valuation shorthand, the enterprise value is derived by multiplying the past year's EBITDA by the enterprise valuation multiple.

To keep this short, the enterprise valuation multiple is higher if:

  • interest rates are lower,
  • the risk (uncertainty) associated with future net cash flow projections being accurate is lower, and/or
  • if the projected rate of growth of annual cash flows is higher.  

By the same logic, the enterprise valuation multiple is lower if:

  • interest rates are higher,
  • the risk (uncertainty) associated with future net cash flow projections being accurate is higher, and/or
  • if the projected rate of growth of annual cash flows is lower.

An important part of this valuation equation is "interest rates."  By this, we mean the risk-free interest rate to which an enterprise-specific risk premium will be added. The risk-free rate is the prevailing yield of the US Treasury note of a relevant term, typically the 10-year US Treasury note. As this rate declines, all else equal, valuation multiples increase, and vice versa.

Why is this relevant to making a decision now?  Well, if you expect this yield to increase significantly, then you would expect, all else equal, for enterprise valuations to decline significantly as well.  In fact, we know that enterprise valuations have been increasing (along with "stock market value") -- they have actually doubled -- as this interest rate has steadily declined over the past decade.  

How Might Interest Rates Move Going Forward?

However, we also see that the long-term downward trend line of this US Treasure note yield, which had fallen in recent years to below 2%, has finally been violated, with the current yield just recently "breaking" above the downward trend line of the past decade, in the immediate aftermath of the US presidential elections.  This may be because president-elect Trump campaigned on a platform of increased government spending on infrastructure and reduced government tax collecting (the combination of which is likely to increase budget deficits and government borrowing), along with reduced free-trade (which typically results in higher consumer and industrial prices for products and services), all of which are considered inflationary factors.   

01.23.2017 US 10 Yr Treas.JPG

As inflationary pressure builds, interest rates tend to increase, sometimes dramatically.  For example, longer-term interest rates rose as high as 17% in the early 1980's, in response to inflationary pressures that had gripped the US economy since the mid 1970's.  The "break" above the downward trend line in interest rates, illustrated above, indicates to many that interest rates will now be trending higher for the foreseeable future.  If interest rates move higher, enterprise valuation multiples will likely move lower.  

The future direction of interest rates matters if you want to secure the highest enterprise valuation multiples ever paid in this industry before these multiples (perhaps) revert towards the lower levels that prevailed throughout most of the history of this industry.