Why Warren Buffett considers interest rates key to stock valuations

The Reserve Bank of India (RBI) hiked the repo rate after nearly four years on Wednesday, as India joined the global rate-tightening wave amid mounting inflationary pressures. In this context, investors remember why Warren Buffett felt interest rates are the “most important item” over time for determining stock valuations.

“The most important factor over time to determine stock valuations is obviously interest rates,” the legendary market investor told CNBC during an interview back in 2017. He explained that if interest rates are lower, it makes any stream of earnings from investments worth more money.

Also read | RBI hikes rate, but analysts see shift to ‘calibrated tightening’ as bigger takeaway. How can this impact markets?

The Oracle of Omaha highlighted that when interest rates rise to high levels such as more than 15%, as the 2-year US Treasury note had done in the early 1980s, it makes higher equity valuation multiples much less attractive. “Any investment is worth all the cash you are going to get out between now and judgment day discounted back. The discounting is affected by whether you choose interest rates like those of Japan or interest rates like those we had in 1982,” he said during the interview in 2017. “When we had 15% short-term rates in 1982, it was silly to pay 20 times earnings for stocks.”

Buffett had said interest rates act like gravity on valuations. He explained that when interest rates were as high as 15% in 1982, they would pull down the value of any asset. “So, what’s the point of buying a farm on a 4% yield basis if you can get 15% from the government's? But measured against interest rates, stocks actually are on the cheap side compared to historic valuations. But the risk always is that — that interest rates go up a lot, and that brings stocks down,” he added.

RBI hikes rates for first time in 4 years

Reserve Bank of India (RBI) Governor Sanjay Malhotra on Wednesday announced the Indian central bank’s Monetary Policy Committee’s (MPC) decision to increase the policy repo rate by 25 basis points to 5.5%, marking the first such hike in nearly four years. It also decided to change the policy stance from ‘Neutral’ to ‘Calibrated tightening’ amid geopolitical uncertainties.

"The MPC noted that the global context, on account of geopolitical developments, remains challenging. Nonetheless, the Indian economy has been strong, and the economic momentum remains broad-based. Moreover, the economy is expected to remain resilient,” Malhotra said.

Also read | RBI hikes repo rate by 25 bps: How are rate-sensitive stocks, sectors faring after first increase in nearly 4 years?

This comes as global bond yields soar to the highest levels in decades, further putting pressure on emerging market equities. The yield on benchmark US 10-year Treasury notes surged close to 5.69%. The 30-year US bond yield jumped close to 5.7% while that on the two-year notes, which moves in tandem with Fed rate hike expectations, rose above 4.8%.

Disclaimer: This article has been written by Debaroti Adhikary, who is not a SEBI-registered Research Analyst or an Investment Adviser. Debaroti Adhikary and his/her ‘relative(s)’ (as defined under Section 2(77) of the Companies Act, 2013) do not hold any financial interest in the companies mentioned in this article as of the date of publication. The views/recommendations mentioned in this article, wherever applicable, are those of the respective SEBI-registered Research Analyst/brokerage and have been reproduced/reported with due attribution. They should not be construed as the views or recommendations of The Economic Times Digital or the journalist. Readers are advised to consider the original research report and make their investment decisions based on their own assessment. Brokerage disclaimers here.