Impact of Interest Rate on Equity Market Valuation

Earning Yield:

Earnings yield is the quotient of earnings per share divided by the share price. It is the reciprocal of the P/E ratio. The earnings yield is quoted as a percentage, allowing an easy comparison to going bond rates.

Bond Yield( also known as Interest Rate ):

A bond yield is the amount of return an investor will realize on a bond. Though several types of bond yields can be calculated, nominal yield is the most common. This is calculated by dividing amount of interest paid by the face value.

It is highly recommended to invest in Equity Market when the Earning Yield is at par or below the bond yields.

Presenting Case of Earning Yields and Bond Yield:

CASE I

Bond Yield in a country is 5% and EPS of the Broad Market Index is 500 and the Market Index is at 10,000 ( in a case where earning yield matches the Bond Yield)

Now the country decides to reduce the Interest Rate by 0.50%

Impact on Equity Market will be that the Market will trade @ 500/(0.05-.005)=11,111 giving 11.11% rise

Now the country decides to increase the Interest Rate by 0.50%

Impact on Equity Market will be that the Market will trade @ 500/(0.05+.005)=9,091 giving 9.09% fall.

CASE II

Indian Equity Market

Today the Earning Yield of Nifty 50 is 4.45% ( PE is at 22.43)

Today the Bond Yield  is @ 7.6045 for 2023 Government Bonds

As per learning, Nifty 50 becomes highly attractive @ PE of 13.15 where the earning yield matches the bond yield.

Taking a three year forward view of Indian Economy.

Most of the Investor feel that the interest rate in India will fall to 4.5% to 5% leading to increase in PE to 22 to 20 respectively.

Taking the Lower PE into consideration and a growth of 7% on current EPS of 364, we can estimate the PE after 3 years will  be around 446 and the Nifty 50 will be 8,920 which is higher than current price and yielding3% annualized return. If you remember Nifty 50 made low of 6,825.80 where if invested for the same target could have yielded 9% annualized return. Assuming that the Equity Yield to match current bond yield market was highly attractive at level of 7150 where if invested for the same target could have yielded 7.6045% annualized return.

If all this cases are read properly and understood, the person can actually evaluate the impact of the rate cut/rate hike expectation prevailing in India and US respectively and its impact on overall equity markets.

Thank you for reading this post.

Inspired,

Tharendra Lunia

Research Wings, Apply wings to happy investing.