The Cost of Money
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 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 value proposition starts there: stocks are risky assets, even riskier than bonds because bondholders are paid their 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 "risk premium". Historically, the risk premium runs at around 7%. This means that if the risk-free rate (the Treasury note rate) is 4%, then investors would demand a return of 11% from a stock. (For a more in depth look at equity risk premium models, exploring their calculations and their assumptions, see The Equity Risk Premium - Part 1 and Part 2.)Therefore, the total return on a stock is the sum of two parts: the risk-free 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 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 the guaranteed Treasury note and for taking on additional risk.
Inverse Relationship
There is an inverse relationship between required return and the stock price investors assign to a stock. 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 required return.
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 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 cheers when the U.S. Federal Reserve announces a rate cut. Conversely, if the Fed raises rates (holding everything else constant), share values ought to fall.
Companies Borrow Too
Interest rates impact a company's operations too. Any increase in the interest rates that it pays will raise its cost of capital. Therefore, a company has to work harder to generate higher returns in a high interest environment. Otherwise, the bloated interest expense will eat away at its profits. Lower profits, lower cash inflows and a higher required rate of return for investors all translate into depressed fair value for the company's stock.
Moreover, if interest rate costs shoot up to such a level that the company has problems paying off its debt, then its survival 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 sluggish economy. They prevent people from buying things and companies from investing in growth opportunities. As a result, sales and profits drop, and so do share prices.
Conclusion
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.
