Interest Rates and PE Ratios

June 13, 2007

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John Forman - The Essentials of Trading author

The other day I talked about the impact of interest rates on stock prices, and how higher interest rates imply lower stock prices by virtue of the discounting of future earnings. Along the same lines, PE ratios are also impacted by interest rates.

Consider the example I brought up in that last post, the one about the stock that is expected to have earnings this year at $1, then seeing those earnings growing by $1 each year up to $5/share in Year 5. At an interest rate of 10%, those earnings would be worth $10.65, while at 5% they would be worth $12.57, which demonstrates why lower interest rates are a positive for stock prices.

Now let’s consider PE ratios.

At 10%, if we assume that the stock is priced at its discounted earnings value of $10.65, the PE for the shares would be 10.65 against expected current year earnings. At 5% the so-called forward PE would be 12.57. So we see that higher interest rates mean higher PE ratios.

Why is this worth knowing?

The biggest reason is to understand where the current PE stands in historical terms. Many stock analyst will look at range of past PE levels to get an idea as to whether the current one is relatively high or low. As we’ve seen, though, PE levels are influenced by interest rates. That means just looking back 5 years, for example, may be a bit misleading. If interest rates during that time are not reflective of current rates (or expected future rates) then an adjustment needs to be made for a true comparisson to be made. Even better, find a comparable historical period to reference.