Interest Rates Matter in 176 Words
What is the value of $2 per year forever?
Well, it depends on your required rate of return.
Let’s assume that all you require is the rate of return found with a 30-year U.S. Treasury Bond, which yields 2.56% annually. If so, the value of receiving $2 forever is $2/0.0256 or $78.125.
What happens if interest rates go up? What if your required return becomes 5%?
The answer: $2/0.05 or $40.
This the simplest illustration of discounting cash flows, but it tells a complicated story. When an analyst is assigned to determine the value of an asset, whether it be a rental house or Apple stock, he/she must discount those cash flows using an appropriate interest rate.
Holding all else equal, if interest rates rates go up, the value of assets goes down. However, if the cash flows are growing, that can offset the increase in interest rates.
That is why the Federal Reserve would like to wait to raise rates until the economy is strong. A strong U.S. economy can absorb the increase in rates.