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What do you mean by "a high interest rate environment means that all that future growth has to be discounted back to a much lower net present value"?
by tinyhouse 4y ago
What do you mean by "a high interest rate environment means that all that future growth has to be discounted back to a much lower net present value"?
- SilverBirch 4y agoYou can think of the value of a stock being the value of all the future profits. So if I know that a company will make $100m in it's lifetime, I can say that company should be worth $100m. But we have to discount that - because money in the future is generally worth less than money today. If I give you a dollar today, you have a dollar, you put it in the bank and collect interest and next year you'll have $1.02 (2% interest). If I give you a dollar next year, you have a dollar. So the dollar today is clearly more valuable than the dollar next year. So what we have to do is look at when the company will make that money, and discount what that money in the future back to what it's value is now. "This is the net present value of future cash flows"[1]. So as interest rates go up, we apply bigger discounts, so companies whose profits won't come for a long time get heavily penalized by this in their valuation. [1]https://www.investopedia.com/terms/n/npv.asp https://www.investopedia.com/terms/n/npv.asp
- tinyhouse 4y agoThanks for the explanation.