What the US FED has said defies the financial mathematics principle and makes finance teachings difficult!
The interest rates have a direct causation effect on the stock market valuation because many financial valuation models have to use risk-free interest rates to derive the stock and asset valuations. How can the interest rates not be responsible for the lofty stock market valuation?
This is the reason we cannot put a lawyer in charge of finance or he will spew nonsense.
I'll do a simple illustration to show the effects of risk-free interest rates on a stock valuation below.
A stock valuation is derived from discounting its future earnings into a net present value (NPV) with a discount rate (risk-free interest rate) over a period.
Let's say the future income is $100m and we will discount it with 3 different discount rates (3%, 2%, and 1%) with a 5-year period.
3% risk-free rate: $100m x (1.03)^-5 = $86.3m (NPV)
2% risk-free rate: $100m x (1.02)^-5 = $90m (NPV)
1% risk-free rate: $100m x (1.01)^-5 = $95.1m (NPV)
As we can see, the lower the discount rate (risk-free rate), the higher is the net present value. Therefore, when financial analysts use lower risk-free interest rates as the discount rates, they will derive higher stock valuations and target prices. The higher stock valuations will inevitably lead to lofty stock markets. Furthermore, the lower interest rates will lead to cheap financing costs for companies and fund managers to borrow to invest or repurchase (buy-back) their shares and push the stock market higher.
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