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Growth Versus Value Stocks: How Interest Rates Affect Valuations

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Growth and value stocks have different sensitivity to monetary policy, but growth companies tend to underperform when interest rates rise due to their long duration cash flows.

Let’s now analyze two imaginary companies, with different earnings profile over the next decade to determine how their value are affected by a changing interest rate environment. To do so, we’ll rely on a basic discounted cash flow model, using the formula below:producer. XYZ is expected to generate $1,000,000 in cash flows next year, and grow them by 4% every year for the next 10 years. Let’s now value this company with the U.S. 10-year yield at 0.25% and then at 3%.

2. Growth company: Company ZZZ is a recently founded tech firm that launched an innovative cloud storage software. ZZZ is expected to generate $50,000 in cash flows next year, and grow them by 90% every year for the next 10 years. Let’s proceed to value this company with the U.S. 10-year yield at 0.25% and then at 3%., but the effects vary across investment styles.

Going back to the two hypothetical examples, growth company ZZZ lost 21.3% of its value when the discount rate used went from 0.25% to 3.0%. In real life, the. Company XYZ was also affected by the change in the rate environment, but its present worth only fell by 14.3%, suggesting that companies with value characteristics may fare better when monetary policy becomes more restrictive.

Focusing on real life examples, the charts below are composed of two panels. The upper panel shows the ratio betweenChart 1 is from January 2020 to May 2020. During this period, when the 10-year yield dropped from about 1.89% to 0.66%, the IWD/IWF ratio declined roughly 19%, pointing to strong growth outperformance.Chart 2 is from January 2022 to May 2022. During this time span, the 10-year yield climbed from 1.50% to about 2.85%.

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