Clipping - Interest Rates

The following is a clipping from a book I read recently on my Kindle. Unfortunately I can't remember which book. If you have ever clipped text using a Kindle you will know it is not well organised with many limitations and it is very easy to become disorganised.

Interest Rates

So what do you use as your investment weather vane to determine interest rate direction and effect? Like so many investing issues, much has been written on this topic. For illustration, we ll use the Ben Graham intrinsic value formula for: Intrinsic value = E x (2g + 8.5) x 4.4/Y where . . . E = annual earnings r = average growth rate y = the interest rate The second expression, (4.4/y), is what s important here. The interpretation is clear: If the interest rate is greater than 4.4, the expression will calculate to less than 1, dragging down the intrinsic value. Similarly, interest rates less than 4.4 result in a positive influence and a tail wind for intrinsic value. Is 4.4 still the right number? Conceptually, Ben Graham s approach is good for value investing calculations. The baseline interest rate, which Graham derived from studying long-term corporate bond rates, is probably a little low by today s standards. Considerable debate exists on what kind of interest rate to use and whether it is a long-term or a short-term rate. Some investors watch 10-year Treasury securities, while others watch the Fed Funds and discount rates

From experience, anything greater than 5.5 percent probably represents a head wind, and anything less than 5 percent for these key rates probably represents a tail wind. Interestingly, as both inflationary pressures (energy and food prices) and recessionary pressures (credit squeeze, home price contractions) existed in the 2006 07 timeframe, the Fed kept the rates right in the middle 5.25 percent for over a year. Interest rates change over time, depending on the economy, inflation and investor expectations. Apart from Graham s intrinsic value formula, interest rates are also a factor in discounted cash flow approaches (introduced earlier in this chapter). Current interest rates affect the discount rate. The higher the current interest rates, the higher the discount rate, resulting in a lower total investment value using the present value formula. Conversely, lower interest rates turn into lower discount rates, which act as a tail wind, and relatively high valuations.

Again, there is more theory than fact on how to quantify the effect of interest rates on discount rates, so the Buffett approach, calling for simple, conservative, generally inclusive assumptions devoid of heavy quantitative analysis, generally makes sense. Buffett would likely set the discount rate at 10 percent in a tail wind environment and closer to 15 percent in a head wind environment.