How Interest Rates Affect Stocks: Discount Rates and Duration

Two lines of arithmetic carry this subject. A company expected to produce $10 per share of free cash flow next year, growing at 3 percent a year forever, is worth 10 / (0.08 - 0.03) = $200 when the discount rate is 8 percent, and 10 / (0.09 - 0.03) = $166.67 when the discount rate is 9 percent.

One percentage point, 16.7 percent of the value, and nothing happened at the company. Almost everything written about interest rates and equities is either an elaboration of that calculation or an account of the many occasions when it failed to describe what markets actually did.

The denominator

The formula is the Gordon growth model, which values a stream of cash growing at a constant rate as CF / (r - g), and its virtue is that the discount rate sits inside a subtraction, so small changes in r produce large changes in value whenever g is anywhere near r. Its weakness is the same property. Nobody should value a real company with it. Everybody should use it to understand sensitivity.

Discount rate	Value of $10 growing 3%	Change from 8%
6%	$333.33	+66.7%
7%	$250.00	+25.0%
8%	$200.00	base
9%	$166.67	-16.7%
10%	$142.86	-28.6%

The effect is asymmetric. A point lower is worth considerably more than a point higher costs, which is part of why equity markets have historically rallied so violently at the moment a cutting cycle comes into view, well before any of the cuts arrive. You can run the same exercise against your own forecasts in the DCF calculator.

Equity duration

The same idea transfers to shares. Bond investors have a precise word for how much a price moves when yields change, set out in duration and interest rate risk, and the further into the future a company’s cash sits, the longer its equity duration and the larger its move for a given change in r.

Compare two companies, both discounted at 8 percent. The fast grower produces $5 next year and grows at 6 percent: 5 / (0.08 - 0.06) = 5 / 0.02 = $250. The steady payer produces $10 next year and grows at 1 percent: 10 / (0.08 - 0.01) = 10 / 0.07 = $142.86.

Now move both discount rates to 9 percent. The fast grower: 5 / (0.09 - 0.06) = 5 / 0.03 = $166.67, down 33.3 percent. The steady payer: 10 / (0.09 - 0.01) = 10 / 0.08 = $125.00, down 12.5 percent.

An identical rate move, and one company loses nearly three times as much as the other. That single piece of arithmetic accounts for most of what people mean when they call growth stocks rate sensitive, and it is the mechanical basis for the long leadership cycles described in growth versus value stocks. The relationship can seem invisible for years. When the risk-free rate barely moves, equity duration costs nothing to own, and investors who learned their habits in such a period have every reason to think the whole subject is overstated until the day it is not.

The slower channel, which nobody watches on the day

The discount rate works on the denominator instantly. Rates also work on the numerator, more slowly, and that delay is why equity markets can look untroubled for several quarters after a tightening cycle has begun.

A company funded with floating-rate debt pays more interest the month after rates rise. A company with fixed-rate debt pays more only when it refinances, so the effect arrives in waves as maturities come due, which is why the shape of a company’s debt schedule matters more in a tightening cycle than the total amount of it. Households meet the same mechanism through credit cards, car loans and mortgages, and housing responds first, because a mortgage payment is such a large share of what a house costs to own.

By the time any of this reaches reported earnings, the rate move that caused it is a year old and the commentary has moved on to something else.

The competition from cash

When Treasury bills pay close to nothing, an investor who wants a return has few places to put money besides equities and credit, and when bills pay a respectable rate the calculation changes: a saver can hold three-month paper, take no equity risk, and still earn something, which raises the return shares have to promise in order to compete.

The formal version of that comparison is the equity risk premium, roughly the earnings yield on stocks minus the yield on Treasuries. A version of it became briefly famous in the late 1990s, when a chart in a Humphrey-Hawkins report to Congress was picked up by analysts and christened the Fed model, and it was used through that decade to argue equities were reasonably valued against bonds. The following decade was unkind to it. The premium tells you how much compensation investors are accepting for equity risk at a given moment, which is useful context. It has never worked as a timing tool.

Sector by sector

Sector	Usual response to higher rates	Why
Technology and biotech	Negative, often sharply	Long equity duration, value sits far in the future
Banks	Mixed	Wider deposit spread helps, an inverted curve and credit losses hurt
Real estate trusts	Negative	Bought for yield, and property is financed with debt
Utilities	Negative	Bond proxies carrying heavy capital spending programs
Homebuilders	Negative early	Mortgage rates set affordability directly
Consumer staples	Mildly negative	Short duration, steady demand, still judged against bond yields
Energy and materials	Depends on the cause	Often rise alongside rates when the driver is growth or commodity inflation

Banks deserve an extra paragraph, because the textbook version gets repeated far more often than it holds, and higher short rates do widen net interest margins when loans reprice faster than deposits, which for a while is genuinely how it works. It stops working when depositors notice and move money into funds that pay more, when the curve inverts so that funding costs more than lending earns, and when borrowers start missing payments. The shape matters as much as the level. That is why the yield curve explained belongs beside any view on bank earnings, and why the yield curve tool is worth opening before you accept the claim that rising rates are good for lenders.

The cycles where rates rose and stocks rose anyway

Every rule above assumes the discount rate changed. Rates move for reasons, and the reason decides what happens to equities.

When yields rise because the economy is accelerating, expected earnings rise as well, the numerator and the denominator grow together, and shares can climb through an entire hiking cycle, which is broadly what happened between 2004 and 2006, when the policy rate was lifted at seventeen consecutive meetings while the equity market advanced, and in a rougher form it describes much of the 1990s.

When yields rise because inflation is running hot and the central bank is tightening into a slowdown, the numerator falls while the denominator rises, and both halves of the fraction work against you. In 1994 the Federal Reserve roughly doubled the funds rate inside twelve months, the bond market had one of its worst years on record, and equities spent the year unsettled and went nowhere. In 2022 the same combination produced something rarer still: government bonds and equities fell together for most of a year, so the hedge that most balanced portfolios rely on stopped hedging at precisely the moment it was wanted. Read a rate move without asking what caused it and one of those two patterns will eventually catch you out.

There is also the question of which rate. The FOMC sets an overnight rate, as described in how the Federal Reserve works, while equity valuations depend far more on the 10-year Treasury yield, which is the bond market’s own verdict on growth and inflation over a decade. The committee can cut while long yields rise, if the bond market decides the cut was a mistake. It has.

What the arithmetic is actually good for

Not timing. Rate expectations are already in prices, assembled from the same releases everyone else reads, and the surprises are by definition the part nobody holds in advance.

It is good for knowing what you own. A portfolio tilted toward companies valued on cash flows a decade out carries an interest rate position whether or not anyone chose it as one, and the size of that position can be worked out with the table above, long before a tightening cycle discovers it for you. Income-paying equities compete against Treasury yields. Redo that comparison at each rebalance.

Start with the institution that moves the short rate in how the Federal Reserve works, then read the release that shifts rate expectations most often in inflation and CPI explained, and the Fed and the economy quiz will then tell you whether the duration arithmetic stuck.