The recent 25 basis point interest rate cut by the South African Reserve Bank on 18 September 2024, coupled with a marginal decline in inflation to 4.4%, signals a shift in the macroeconomic landscape. These developments highlight the delicate balance between controlling inflation and promoting economic growth.
Macroeconomic factors play a pivotal role in shaping company valuations, with inflation and interest rates being two of the most influential. While each has a distinct impact, their interconnectedness adds complexity to how they affect asset prices and financial markets.
Investors and analysts rely on macroeconomic data to forecast future profitability, evaluate risks, and refine their expectations. The interconnectedness among macroeconomic indicators, such as inflation and interest rates, has a significant impact on:
- Discount rates: The discount rate used in valuation models, such as Discounted Cash Flow (DCF), is directly affected by interest rates. A lower discount rate, driven by interest rate cuts, increases the present value of future cash flows, potentially increasing the company’s value.
- Cost of capital: Both inflation and interest rates affect the cost of capital. Rising interest rates typically make borrowing more expensive, while high inflation erodes purchasing power, impacting a company’s ability to invest and grow.
- Consumer demand: Inflation impacts consumer spending, while fluctuations in interest rates influence saving and borrowing behaviors. Together, these factors can significantly affect a company’s revenue growth potential in certain sectors.
Interaction between interest rates and inflation
Inflation and interest rates are closely linked. Central banks, like the South African Reserve Bank (SARB), use interest rates as a primary tool for managing inflation. This relationship unfolds in the following ways:
- Inflationary pressures lead to higher interest rates: When inflation increases, central banks generally raise interest rates to cool the economy and prevent it from overheating. Higher rates discourage borrowing and spending, which in turn reduces demand and helps stabilise prices.
- Decreasing inflation leads to lower interest rates: When inflation begins to slow – recently evident by South Africa’s slight decline to 4.4% – central banks may lower interest rates to stimulate economic growth. The SARB’s recent 25 basis point rate cut is an example of this response to easing inflationary pressures.
Impact on company valuations
- Interest rates: When interest rates decline, as they have recently, the lower cost of borrowing tends to benefit companies, particularly those that are capital-intensive. A reduction in interest rates leads to lower debt-servicing costs, higher net income, and ultimately higher valuations. It also reduces the discount rate used in financial models, which increases the present value of future cash flows.
- Equity valuation: Interest rate cuts also influence equity valuations. Investors seeking higher returns may shift from bonds to equities when interest rates fall, driving up stock prices.
- Cost of debt: Companies with significant debt benefit from reduced interest expenses, freeing up cash flow for expansion or dividends, which positively impacts valuation.
- Inflation: While moderate inflation is generally associated with economic growth, excessive inflation can erode a company’s purchasing power, increase operating costs, and squeeze profit margins. In valuation terms:
- Cash flows: Inflationary pressures can reduce future real cash flows, especially if a company struggles to pass on higher costs to consumers.
- Valuation multiples: High inflation, if not accompanied by strong economic growth, may lead to lower valuation multiples due to increased uncertainty and risk.
The current environment, marked by falling interest rates and marginally declining inflation, offers a supportive backdrop for company valuations. The decrease in inflation, albeit marginal, reduces cost pressures, while lower interest rates boost borrowing capacity and reduce the discount rate in valuation models.
Looking ahead, the expectation of further reductions in the interest rate in November may offer additional support for company valuations, especially as borrowing costs continue to decrease. Investors and analysts should remain vigilant, as ongoing shifts in inflation and interest rate policy will be key drivers of market movements and asset prices in the coming months.
