If you're ever looking for a topic to help wrap up a conversation quickly so that you can be left alone to think about your investments, then start talking about interest rates. Your listen🏅er's eyes are guaranteed to gl🌠aze over, and you'll be alone in no time.

But for those who own investments, the topic is not as dry as you think. In fact, it is something investors should make an effort to understand. According to financial theory, interest rates are fundamental to company 澳洲幸运5开奖号码历史查询:valuation, and ཧtherefore play an impor♋tant role in how we put a price on stocks.

Here we take a look at the relationship between interest rates📖 and stock price๊. 

Interest Rates and Risk Premium

Think of an interest rate as the cost of money, which just like the cost of production, labor, and other expenses is a factor of a company's profitability.

The fundamental cost of money to an investor is the 澳洲幸运5开奖号码历史查询:Treasury note rate, whose return is guaranteed by the "full faith and credit" of the U.S. government. According to financial theory, a stock's 澳洲幸运5开奖号码历史查询:value proposition starts there: stocks are risky assets, even riskier than bonds because bondhol💧ders are paid 𓆉their capital before stockholders in the event of bankruptcy. Therefore, investors require a higher return for taking on extra risk by investing in stocks instead of Treasury notes, which are guaranteed to pay a certain return.

The extra return that investors can theoretically expect from stocks is referred to as the "澳洲幸运5开奖号码历史查询:risk premium." Historically, the risk premium runs at around five percent. This means that if the risk-free rate (the Treasury note rate) is four percent, then investors would demand a return of nine percent from a stock. Therefore, the 澳洲幸运5开奖号码历史查询:total return on a stock is the sum of two parts: the risk-fr🌌ee rate and the risk premium.

If you want higher returns, you must invest in riskier stocks because they offer a higher risk premium than, say, stronger 澳洲幸运5开奖号码历史查询:blue-chip companies. In theory, rational investors will select an investment with a return that is high enough to compensate for the lost opportunity of earning interest from th🉐e guaranteed Treasury note and for taking on additional risk.

Required Rate of Return

If the required return rises, the stock price will fall, and vice versa. This makes sense: if nothing else changes, the price needs to be lower for the investor to have the 澳洲幸运5开奖号码历史查询:required return. There is an inverse relationship between the required return and the stock pr﷽i💙ce investors assign to a stock.

The required return might rise if the risk premium or the risk-free rate increases. For instance, the risk premium might go up for a company if one of its top managers resigns or if the company suddenly decides to lower its dividend payments. And the risk-free rate will increase if interest🌠 rates rise.

So, changes in interest rates impact the theoretical value of companies and their shares — basically, a share's 澳洲幸运5开奖号码历史查询:fair value is its projected future cash flows discounted to the present using the investor's required rate of return. If interest rates fall and everything else is held constant, share value should rise. That's why the market generally cheers when the 澳洲幸运5开奖号码历史查询:U.S. Federal Reserve announces a rate cut. Conversely, if the Fed raꦅises rates (holding everything else cꩲonstant), then share values are likely to fall.

How Interest Rates Affect Companies

Interest rates impact a company's operations too. Any increase in the interest rates that it pays will raise its 澳洲幸运5开奖号码历史查询:cost of capital. Therefore, a company has to work harder to generate higher returns in a high-interest environment. Otherwise, the bloated 澳洲幸运5开奖号码历史查询:interest expense will eat away at its profits. Lower profits, lower cash 🔜inflows, and a higher required rate of retur🔜n for investors all translate into depressed fair value for the company's stock.

Additionally, if interest rate costs shoot up to such a level that the company has problems paying off its debt, then its surv♚ival may be threatened. In that case, investors will demand an even higher risk premium. As a result, the fair value will fall even further. 

Finally, high-interest rates normally go hand-in-hand with a 澳洲幸运5开奖号码历史查询:sluggish economy. They p🙈revent people from buying things and companies from investing in growth opportunities. As a result, sales and profits drop, as do share prices.

The Bottom Line

In financial theory, valuation begins with a simple question: if you put money into this company, what are the chances you will get a better return than if you invest in something else? Interest rates play an important🌳 part in determining what that something else might be.