Interest Rates and Equity Markets — The Pulse That Reprices Everything

"This is the moment where the concept finally clicks: rates aren't an annoying footnote to stocks — they're often the stage manager rewriting the script."

Quick hook (no re-intro to the course — we build on what you already know)

Remember the Earnings Multiplier Model and the valuation tweaks in Valuation Adjustments? Great. Now imagine the economy flips the main dial those models sit on: interest rates. Everything from the discount rate in your DCF to the multiple investors are willing to pay for growth gets tugged by yield moves. If valuation models are the math, interest rates are the climate.

Why care? Because whether you're sizing positions, arguing about cyclicals vs. growth, or estimating terminal value, rates change the arithmetic and the psychology of equity prices.

What we mean by "Interest Rates" (and which ones matter)

• Risk-free rate — typically the nominal yield on US Treasuries (e.g., 10-year). Forms the base of discount rates.\
• Real rate — nominal minus expected inflation; this drives real returns and long-run discounting.\
• Term premium — extra compensation for long-duration risk, fluctuates with supply/demand and macro risk.\
• Policy/short rates — Fed funds; influence borrowing costs, liquidity, and forward economic expectations.

All of these affect the components you already use in valuation: the cost of equity, cost of debt, and the equity risk premium adjustment in your models.

The mechanics — how rates change equity values

The classic formula (and your old friend)

From the Gordon-style simplification (a core intuition behind the Earnings Multiplier):

Price P = E / (r - g)

Where: E = expected earnings per share next period, r = required return (cost of equity), g = growth rate.

So: dP/dr = -E / (r - g)^2 — price sensitivity to interest rates grows non-linearly as r approaches g. Translation: when rates are low (r close to g), a small rise in r causes a big fall in P.

Practical takeaways

• Low-rate regime → stretched multiples: small increases in yields can blow up price declines (we saw this in 2022).\
• High-rate regime → compressed duration: investors reweight to earnings and cash-flow today (value beats growth).\
• Duration matters: growth stocks have higher "equity duration" (cash flows far in the future) so they react more to rate changes than cyclicals.

How this plugs into Valuation Adjustments and Earnings Multipliers

• Cost of equity: r = risk-free rate + beta * ERP (equity risk premium). When Treasury yields rise, the risk-free component rises and r increases directly.\
• ERP dynamics: ERP itself can contract when real rates rise in a calm normalization or expand during stress — so the net effect on r is not purely mechanical.\
• Multiples: P/E ≈ 1 / (r - g) (loosely). So rising r compresses P/E multiples; your valuation adjustments should reflect that shift — not just earnings revisions.

Pro tip: when you updated valuations previously under "Valuation Adjustments," make sure the scenario matrix includes alternative yield-curve assumptions (not just earnings surprises).

Sector and style sensitivities (real-world, not just theory)

• Growth/tech: high duration. Small r moves → big multiple swings. Think: long-dated profits, heavy R&D, high reinvestment.\
• Value/cyclicals/financials: lower duration or positively correlated to rising rates (banks benefit from wider net interest margins).\
• Utilities and REITs: income proxies — compete with bonds; their dividend yields are compared to treasury yields closely.

Historical example: 2020–2021 low-rate era pushed tech multiples sky-high. In 2022, rapid hikes caused multiple contraction and a rotation to value and energy.

Beyond the headline rate: 3 nuanced channels

1. Discounting channel — direct effect on valuation formulas (cost of capital). The dominant mechanical driver.\
2. Earnings channel — higher rates can slow growth (higher borrowing costs, capex cuts), reducing E or g. This is slower, more structural.\
3. Flow/market-risk channel — portfolio flows, risk appetite, and leverage unwind. Examples: carry trades collapse, margin calls amplify selling.

Ask yourself: Is the price move driven by changing r, changing g, or a re-pricing of risk appetite? The answer defines whether the move is temporary or fundamental.

A tiny calculation (try this in your models)

Imagine a firm with E = $5, g = 3%.

• If r = 6% → P = 5 / (0.06 - 0.03) = 166.67
• If r rises to 7% → P = 5 / (0.07 - 0.03) = 125.00

That's a ~25% drop in price from a 1 percentage point rise in r. Ouch.

Code snippet (quick sensitivity):

# Python-ish pseudocode
E = 5
g = 0.03
for r in [0.06, 0.07, 0.08]:
    P = E / (r - g)
    print(r, P)

This highlights why growth stocks (smaller g differences relative to r) are fragile to rate increases.

Conflicting perspectives — when rates tell different stories

• Some say: Rising real rates = stronger economy → earnings growth compensates, stocks can hold. True in earnings-led rallies where growth expectations rise faster than discount rate.\
• Others: Rising rates kill multiple expansion and trigger rotation. Also often true, especially when rate rises are unexpected or disorderly.

Why both can be right: timing and channel matter. A gradual rise with improving real growth can sustain equities; a rapid shock to rates without growth pickup compresses valuations.

Practical checklist for analysts and PMs

• Stress-test valuations under multiple yield-curve scenarios (parallel shifts, steepening, flattening).\
• Compute equity duration for your names: how much does price change per 100bp change in rates?\
• Revisit ERP assumptions — are they adding or subtracting when yields move?\
• Sector tilt: overweight lower-duration beneficiaries when expecting higher-for-longer rates.\
• Watch liquidity and margin environments — they amplify flows beyond fundamentals.

Closing: The memorable insight

Interest rates are the gravitational field of finance — they bend valuation space. Your Earnings Multiplier and Valuation Adjustment tools are the spacecraft: great pilots understand how gravity wells (rates) reposition trajectories.

Key takeaways:

• Rates affect both arithmetic (discount rates) and psychology (risk appetite).\
• Growth = high duration = high rate sensitivity.\
• Model both r and g: rising rates can be offset by rising growth, but not always.\
• Always scenario-test yields — the term structure shape matters.

Why do people keep misunderstanding this? Because they treat rates as a single number rather than a dynamic structure that touches cost of capital, growth expectations, and market flows simultaneously.

Go edit your spreadsheets, run a few yield scenarios, and then come back and tell me which sector you'd rather hold if the 10-year spikes 150 bps tomorrow — we'll argue it out like grad students with coffee and conviction.

Further reading suggestions (quick)

• Research note: Equity Duration and the Interest Rate Exposure of Growth Stocks\
• Fed minutes and the Treasury term premium research for macro context