Expert: Paul Henneman - 5/10/2004

Question
Hello:

I want to thank you for the helpful reply. However, I do have this follow-up question.

Investors believe in general that higher rates will prevent a company from growing; I assume that this means earning money for the company, keeping the money as profits.
It is difficult for a company to make money for itself because the money it makes is used to pay the borrowed amount from the higher interest rates instead of being kept as profits.
Investors want to invest in companies that are profitable, so higher interest rates prevent some, but not all, companies from being profitable.
If a company's profits or earnings fall or do not grow, some investors are no longer interested in owning the stock from the company. Many investors will sell the stock and this large-volume selling will cause the stock price to fall.

Is this explanation somewhat correct?
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Followup To
Question -
Hello:

Why do interest rates affect the prices of stocks?
Higher interest rates, or even the mention of higher interest rates, most generally cause stock prices to decline.

I thank you for any helpful reply that is provided.
Answer -
Thank you for your question!
Interest rate as defined by the "Barrons Guide to Finance and Investment Terms" is: "rate of interest charged for the use of money, usually expressed at an annual rate." (p. 285)  For your question, this applies to business loans.
Essentially high interest rates make it more expensive for businesses to borrow money to expand their operations. If interest rates rise, businesses have to pay higher interest on their business loans, so are more likely to not undertake expansion as it becomes too expensive. This causes in general a stock price drop as investors are aware that higher interest rates make it more expensive for companies to grow.
However, if the economy is very, very strong and growing, businesses may still take on this additional expense for the opportunity to grow. It all depends upon how strong the economy is and the prospects for growth. If very good, paying more interest may still be a good move. And each business is different and will postpone or continue with expansion plans based on rising interest rates differently. The above is only a general rule when talking about the stock market overall.

I hope this helps! Please do not hesitate to follow up with me if I can be of any additional service.

Sincerely,
Paul Henneman
President
ValuEngine, Inc.
www.ValuEngine.com  

Answer
Thank you for your follow up!
You are on the right track, but a few things I would modify regarding your follow up.
First, it is not related to directly making money, but instead is releated to the ability to borrow money, grow the company, and therefore make more money in the future. So interest rates affect the ability of a company to grow. Growing companies means the stock price rises, so if companies are limited in their growth potential, the stock price will likely not rise, or even fall.
Also, the rising interest rates do not affect current loans that a company may have. Interest rates are usually fixed, so it only affects new loans. As interest rates rise, companies will be less likely to borrow money as it becomes more expensive to do so, so growth is reduced.

I hope this helps!

Sincerely,
Paul Henneman
President
ValuEngine, Inc.
www.ValuEngine.com