Editorial staff
These days, investors face a complex array of considerations when evaluating the worth of a business or an asset. The two most important, and least understood, are inflation and interest rates — two of the great forces of macroeconomics that permeate virtually every corner of the financial world. They are profound for intrinsic valuation: how we set discount rates, how we approach capital budgeting, and how we think about risk, all of which change as economic growth changes.
In this section, we examine the dynamic interplay between inflation, interest rates, and intrinsic value. It also utilizes creative professional discussions on some fundamental problems with Alphaspread to help understand and put these concepts into practice. On the other hand, such macroeconomic indicators, including their data and impacts, are not confined to aggressive institutional investors; as a retail investor, you should also pay attention to them when making informed investment decisions.
Understanding Intrinsic Valuation
At the heart of intrinsic valuation is the concept of determining a company's "true value", even if it is not trading on the market in a way that reflects this. This is not the same as a relative valuation, which values a company based on trade with its close comparable peers. The primary concept was to estimate future cash flows and discount them to their present value using a suitable discount rate (Levitin, 2008).
The DCF is the most commonly used intrinsic valuation model. It is estimated using the DCF technique, based on the expected free cash flow of the company, and discounted at a suitable rate that reflects the time value of money and changing degrees of risk. This is where the discount rate can potentially obscure the true intrinsic value: inflation and interest rates have a significant impact on the discount rate.
Valuation platform investors, such as those of Alphaspread, tend to employ an ensemble of in-sample models that adjust/hedge inputs to account for the dynamics of the evolving macro-environment. This adaptability is crucial for well-informed decisions relating to transactions.
Inflation's Multi-Layered Impact on Valuation
Inflation and Cash Flow Erosion
Your purchasing power gets eroded with inflation. For businesses, this means higher operating costs — labor, materials, and other inputs become more costly. If businesses can not recoup this cost by raising prices to customers, profit margins are squeezed, and next year's free cash flow shrinks. And even if nominal revenue increases, it could still see real cash flow — revenue adjusted for the inflation rate — remain flat or decline.
The decrease in real cash flow resulting from this directly reduces intrinsic value. Products like Alphaspread help investors model a range of inflation scenarios to see how much a company's valuation is at the mercy of how high input costs can rise and how much the company can pass these higher costs along.
Inflation and Discount Rates
Another noteworthy issue is how inflation influences the discount rate. Higher inflation typically results in higher nominal interest rates and a higher required return on investment. If the discount rate increases, then the Present Value of future cash flows is lower, and therefore the intrinsic value of the business is reduced.
For example, consider a company that is projected to fall short of its expected $10 million in annual revenue over the next decade. In a 2% inflation world, the discount rate might be 6%, but if inflation increases to 6%, the discount rate could jump to 10% or even more. That single adjustment can reduce the company's intrinsic value by 30 or 40% or more.
Using sites like Alphaspread, investors can model the impact of inflationary pressures and changes in the discount rate on the valuation curve of a particular sector/company.
Interest Rates as a Valuation Lever
Direct Effect on Discount Rates
Interest rates, typically determined by central banks, are one of the most explicit inputs into the discount rate incorporated in valuation models. The risk-free rate, often represented by the US Treasury yield, serves as a base for most discount rate measures. With this increase in interest rates, the risk-free rate also rises, and the general discount rate increases.
This leap in the discount rate leads to a dramatic decrease in the present value of future earnings, making many high-growth companies, whose cash flows are back-ended, appear dramatically overvalued. And that's exactly why tech and growth stocks are more likely to be hurt by rising interest rates.
With a valuation platform like https://www.alphaspread.com/, investors can input different risk-free rate assumptions and observe how their intrinsic value models change in real-time. This enables more informed decision-making regarding forward-looking interest rate expectations.
Capital Cost and Investment Decisions
Caps also affect a company's cost of capital. Rising borrowing costs can also deter companies from borrowing to expand, crimping growth potential. Likewise, higher interest rates make yieldless alternative investments, such as bonds or savings accounts, more appealing compared to stocks, diverting capital from stock markets.
When rates are high, valuations in stocks tend to compress. On the contrary, a low interest rate setting often stokes more expensive valuations, especially in growth stocks with long-dated cash flows. By developing dynamic models, sites like Alphaspread can facilitate a reevaluation of a firm's WACC, resulting in an adjustment of the fair value.
Interaction of Inflation and Interest Rate
The two factors, inflation and interest rates, are likely to influence the intrinsic value independently, but they are also often interdependent. Central banks typically respond to surging inflation by raising interest rates to cool off an overheating economy. This policy intervention, meanwhile, affects not only market values but also consumer appetites, corporate investment, and economic growth.
And when that's the case, and this intertwined nest of mediums is certainly one of those cases, investors must look to macro-indications and policy responses when considering valuations. For example, suppose inflation rises and policy forces interest rates to remain low (or, in the case of negative rates, to stay low or even lower). In that case, real interest rates (meaning the nominal rate minus the inflation rate) may become negative. This has the effect of inflating asset bubbles as investors seek higher yields by moving into riskier assets.
Valuation tools, such as Alphaspread, can enable investors to gain better forward visibility and manage risk, and can encourage scenario analysis within valuation models.
Sector-Specific Sensitivity
Growth vs. Value Stocks
Growth stocks, which derive most of their value from future earnings, are particularly vulnerable to rising discount rates. Higher interest rates, even slightly so, can dramatically lower their valuations.
Value stocks, however, tend to experience less pain because they generate stronger near-term cash flows. In an environment of inflation or elevated interest rates, investors tend to shift from growth to value, triggering sector rotation, which can have a significant impact.
Real Assets and Commodities
Companies in real assets — or things we can touch and feel, like energy, mining, or real estate — often benefit when the things these companies produce or own increase in value in inflationary times. But they, too, are subject to changes in interest rates, especially those that are heavily leveraged.
By breaking out companies by industry and sector, tools such as alphaspread show a more nuanced picture of how inflation and interest rates affect companies of a given type. It permits the investor to construct a portfolio appropriate to that type of macro trend and demonstrate resilience in a value sense.
Real-life Application: Tech Valuations in Rate Hike Cycles
The technology sector has been a textbook example of sensitivity to interest rates in recent years. When interest rates were near zero, tech firms with ambitious growth forecasts experienced a surge in value. Investors felt safe projecting 10-15 year cash flows and discounting them very little.
However, those tech valuations plummeted when inflation surged back in 2021–2022 and central banks implemented aggressive rate hikes. Companies like Zoom, Shopify, and, yes, even Amazon, also experienced steep devaluations not because the quality of their business had deteriorated but because the discount rate environment itself had fundamentally shifted.
Investors and analysts using alphaspread would be able to observe these shifts in the model valuations on the platform. Providing timely insight into when buy and sell decisions might be indicated.
Strategic Implications for Investors
Dynamic Discounting
In a macroeconomic environment of uncertainty, investors must utilize flexible valuation models that allow for scenario analysis. Discount rates ought not to be fixed. Instead, they should only reflect inflation expectations, central bank policy, and market risk appetite.
Sites such as alphaspread allow you to adjust inputs dynamically, providing superior techniques to predict valuation when circumstances change.
Margin of Safety
In times of economic hardship, a margin of safety is even more crucial. Intrinsic valuation models give a theoretical fair value, but the disciplined section of investors strives to acquire at a discount to that value. With added inflation and interest rate uncertainty, the likelihood of pricing mistakes is augmented, making conservative buying points all the more important.
Holistic Approach
A mix of fundamentals and macro is what investors should focus on. Disregarding inflation in valuation work, or changes in interest rates, is a recipe for mispricing risk. As far as I know, Alphaspread is one of the only valuation platforms that has macros built and real-time recalculations, which I've been referring to here.
Conclusion:
Today, with interconnected and interdependent markets, intrinsic value should no longer be considered in a vacuum. Inflation and interest rates are not side issues — they go to the heart of what an investment is worth.
Editorial staff
