An Empirical Analysis of the Effect of Changes in Interest Rates on Accounting Rates of Return, Growth, and Equity Values

Abstract

This paper examines whether the documented negative correlation between changes in interest rates and stock returns is also observed in the fundamentals on which equity values are based. The negative correlation is often attributed to changes in the discount rate, a denominator effect in a valuation model. However, there may also be a numerator effect on the expected payoffs that are discounted, and it is this effect that the paper examines. The paper documents the effect of changes in interest rates on accounting profitability and asset growth that are tied to expected dividends and value in the residual earnings valuation model. The effects of changes in both real and nominal interest rates are investigated so that the effects of changes in expected inflation (that has been the focus of much of the research on interest rates and stock returns) are isolated. Accordingly, the paper evaluates the Modigliani and Cohn conjecture that investors do not understand the effect of changes in expected inflation on firms. The results show that both real and nominal rates are positively related to subsequent profitability and growth, at least in the near term. So, increases in interest rates are followed by higher profitability and growth. However, the resultant increase in earnings is typically not large enough to cover the increase in the required return from the increase in the interest rate. So the overall effect on equity value is negative, consistent with the results of the research on interest rates and stock returns.