Tackle Today: Discounting Cash Flows
January 20, 2022
≈ On the time value of money. ≈
Traders,
Yesterday we looked at the first reason rising rates matter: it increases the cost of capital. Today we’re discussing the second reason: it lowers the value of future profits.
To understand the adverse impact of higher interest rates, you first must grasp that $1 today isn’t necessarily worth the same as $1 in the future.
The reason is simple. The money you have today can be invested immediately and generate some rate of return. However, the money you get in the future cannot be invested today and will therefore miss out on any returns between now and then.
Thus, we must discount all future profits from a business (which is usually referred to as future cash flows) by a certain amount to figure out what it would be worth today. In other words, to determine its net present value.
When interest rates are zero, future profits don’t need to be discounted because there are no risk-free returns.
But if interest rates rise to 1%, then future profits need to be discounted because now there are risk-free returns available.
The higher the rate, the less future profits are worth.
This should help explain, in part, why growth stocks are getting torched. Many of these companies aren’t profitable today. But they might be in the future! And those future profits are about to become less valuable if the Fed does indeed raise rates four times in 2022.
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