When rates have risen in the past, that has been bad for stocks. Some say rising interest rates affect stocks because you need to increase the discount rate on stocks and that will drive prices lower.

It makes some sense. If investments are competing for my next dollar,  it is true that treasuries at 3% look a lot better than <1%.

I have already argued that I am bearish on the notion that interest rates will rise much further from here.

I have based that on (i) real long-term interest rates are lower than people probably think, but are skewed by the high rates of 80s & 90s, (ii) demographic headwinds (baby boomers aging will roll into lower risk securities), (iii) technological improvements are a large deflationary headwind, which will keep rates in check, and (iv) global interest rates remain very low compared to the US and the US is the best house in a bad neighborhood, which will drive increased demand for US$. A strengthening dollar also puts downward pressure on inflation.

I also argued that the Fed has little impact on long-term rates actually (and check that with Aswath Damodaran writings on the subject as well)

Given rates moved up quickly from their lows to ~3.2%, I wanted to show interest rates affect on stocks using a hypothetical company. 

I have made these numbers up, but used average S&P EBITDA and EBIT margins for my starting assumptions, assumed a 25% incremental margin, and a 27% tax rate. I also assumed capex = depreciation as this example is a mature business and growing only at about GDP (3%).

Here’s a summary below of where it is currently trading and model:

As shown, the company is currently trading around 12x LTM EBITDA (average S&P company trades for 12.5x LTM). Let’s see if this particularly equity looks cheap based on a DCF. I use both the terminal multiple method and the perpetual growth method below.

As you can see, the implied prices I get are right around the stock’s price today meaning the stock is trading for fair value. What’s the downside if interest rates go up 1%?

Well first, we need to access the impact on our weighted average cost of capital, or WACC. I assume the risk free rate is 3%, as it is today, the beta of this stock is 1.1, and the equity risk premium is ~5%, in-line with long-term history. I also assume the cost of debt is ~5.5%. It is important to remember that many company’s have fixed and floating rate debt.

As such, a 1% increase in the 10 year won’t actually impact a company with fixed rate debt until they need to reprice it. But for conservatism, I assume it is a direct increase in their cost of debt. Bottom line: I increase the WACC by 1%.

So how does this translate into our company? Well, as seen below in the bottom right box, a 1% increase in the discount rate would have a ~5% impact on our stock value, all things being equal.

Bottom line: Interest rates really have not moved to 4% and so I am skeptical of the 10% correction in stocks today and the increase in rates thus far actually impairing their prospects. Rising rates simply do not affect stocks this much.