Posts Tagged ‘cash flows’

HOW IMPORTANT IS INTEREST RATE?

Essentially, interest is nothing more than the cost someone pays for the use of someone else’s money. In India, an individual willing to purchase a home uses bank’s money (through a mortgage) and in return pays interest to the bank for the privilege or the credit card user borrows money for the short term in order to buy something right away. But the very question that comes to everyone’s mind is how to determine where the rates are heading & what impact will it have?

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So in order to find where the interest rates are heading all one needs to do is to look at the deposits & loans advances of the banks. If banks credit growth is more than its deposits then banks may raise the deposit rates or may increase the lending rates in order to match the asset & liability mismatch. When the Central Bank (RBI) feels that the credit growth has started picking up & is higher than its target levels, RBI tinkers with its policy rates gives signals to the commercial banks to review the interest rates be it on the deposit front or on the lending front.

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Effects of the rising interest rates On individuals

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The first indirect effect of an increased rate is that banks increase the rates that they charge their customers to borrow money. Individuals are affected through increases to credit card and mortgage interest rates, especially if they carry a floating interest rate. This has the effect of decreasing the amount of money consumers can spend. After all, people still have to pay their EMI’s, and when these installments become more expensive, households are left with less disposable income.

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On the Corporates financials

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Corporates too borrow money from banks to run and expand their operations. When the banks make borrowing more expensive, corporates may  not borrow at all or may not borrow at the same pace that they were doing when the rates were lower. Less business spending can slow down the growth of a company, resulting in decreases in profit.

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Even businesses are also indirectly affected as a result of the actions of the individual consumers as individuals are left with less disposable income which affects the company’s top & bottom lines (that is, revenue and profits). Apart from having an indirect affect businesses are affected in a more direct way as well.

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On GDP Growth

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The government essentially has two weapons in its arsenal to help guide the economy towards a path of stable growth without excessive inflation; monetary policy and fiscal policy. Fiscal policy comes from the government in the form of taxation and federal budgeting policies. While fiscal policy can be very effective in specific cases to spur growth in the economy, most market watchers look to monetary policy to do most of the heavy lifting in keeping the economy in a stable growth pattern. Monetary policy is defined as any action to limit or increase the amount of money that is circulating in the economy. That means the central bank (RBI) can make money easier or harder to come by, thereby encouraging spending to spur the economy and constricting access to capital when growth rates seem to be approaching unsustainable levels.

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Stock Price Effects

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Clearly, changes in the rates affect the behavior of consumers and business; hence the stock market is also affected. Remember that one method of valuing a company is to take the sum of all the expected future cash flows from that company discounted back to the present. To arrive at a stock’s price, take the sum of the future discounted cash flow and divide it by the number of shares available. This price fluctuates as a result of the different expectations that people have about the company at different times and are willing to buy or sell shares at different prices. If the company is seen as cutting back on its growth spending or is making less profit – either through higher debt expenses or less revenue from consumers then, the estimated amount of future cash flows will drop. All else being equal, this will lower the price of the company’s stock.

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Investment Effects

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With a lowered expectation in the growth and future cash flows of the company, investors will not get as much growth from stock price appreciation, making stock ownership less desirable. Furthermore, investing in stocks can be viewed as too risky as compared to other investments. When the central bank raises its rate, newly offered government securities, such T- bills and bonds, are often viewed as the safest investments and will usually experience a corresponding increase in interest rates. In other words, the “risk-free” rate of return goes up, making these investments more desirable.

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Conclusion

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We should keep in mind, however, that these factors and results are all interrelated. What we described above are very broad interactions, which can play out in innumerable ways. Interest rates are not the only determinant of stock prices and there are many considerations that go into stock prices and the general trend of the market – an increased interest rate is only one of them. Therefore, one can never say with confidence that an interest rate hike will have an overall negative effect on stock prices.

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Stay Tuned for More Updates :)

Where Are We Heading To? Part 2

Indian Stock Market Growth

From the positive happenings in the economy, let’s see how the stock markets have behaved amidst all this?

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The price charts of many companies reflected that the investors were in a catch-up mode.

This was evident from the stock price trajectory of most stocks, which saw a sharp spike in few days.

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In many cases, the stock prices nearly doubled in a matter of few trading sessions.

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It’s a kind of emotion that grips a commuter when he/she loses a train or bus by a fraction of a second.

When we see a bus/train departing in front of our eyes, we rush towards to it without caring about the risks involved.

What if you hurt yourself badly in the process? But who cares?

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Those days seem to be back where most of the frontline stocks are at their 52-week highs or better, but, still their valuations, measured by various ratios such as price-to-earning multiples or price-to-book value among others are far from the highs of 2008.

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Valuations come with expectations. 🙂

Higher the valuations, greater is investor expectation from that particular stock.

To justify the elevated valuations, corporate earnings have to grow at a significant rate.

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Companies also have to improve the quality of earning i.e. the profit growth has to be accompanied with an equally rapid rise in cash flows and dividends payouts.

But can this really happen? To support this, we have the World Bank statement, who said that India would grow 8.1 per cent in 2010, ahead of China (7.5 per cent).

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The numbers in the survey also suggest India is finally ready to rub shoulders with its northern neighbour.

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The point is, India is better placed to face the economic slowdown as compared to other large economies because of the diversified nature of the economy in which some sectors witness robust demand to mitigate the impact of a demand slowdown in other sectors.

It is clear that the Indian economy is recovering from the clutches of the world economic crisis.

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Even the performance of the stock market has shown signs of revival of investor interest and confidence, both domestic and

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The confidence of FIIs in India started to built up in the last few months which is evident from the FII figure mentioned above and tends to be in upbeat mood going forward.

Therefore, even if economic growth does recover in India, it would be a different than what we have seen in the past.

And to gain, investors will have to offload baggage of the past and look at the future afresh.

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