How do interest rate changes affect stock valuations?

Stock prices are the present value of expected future cash flows, so changes in interest rates alter valuations by changing the discount rate applied to those cash flows and by influencing the cash flows themselves. Aswath Damodaran at New York University Stern School of Business emphasizes that the discount rate combines a risk-free component and a risk premium, so a rise in policy or market interest rates typically raises the discount rate and reduces the present value of distant earnings. Myron J. Gordon at the University of Toronto formulated the Gordon Growth Model, which formalizes how a higher required return compresses equity values for a given stream of future dividends.

How interest rates change the discount rate

When central banks lift short-term policy rates, markets generally reprice yields across the curve. Federal Reserve research shows that changes in the term structure and expectations about future rates feed through to longer-term government yields, which serve as the baseline risk-free rate for valuation models. Higher risk-free rates make future cash flows less valuable today, especially for firms whose earnings are expected far into the future. In addition, rising rates can increase equity risk premia if investors demand more compensation for risk during tightening cycles. Conversely, falling rates lower discount rates and can lift valuations even without any change in corporate fundamentals.

Interest-rate moves also affect expected cash flows. Tighter policy raises borrowing costs for companies and households, which can slow investment and consumption and reduce corporate profits. Monetary policy impacts credit availability and corporate leverage; firms that are interest-rate sensitive see both their cost of capital and their projected earnings change. Federal Reserve economists have documented these transmission channels, noting that the net effect on stock prices depends on the balance between lower discount rates and any weakening in fundamentals.

Sectoral and territorial consequences

Interest-rate changes do not affect all firms equally. Growth-oriented companies with earnings far in the future, such as many technology firms, are more sensitive to discount-rate shifts. Value and financial sector firms often respond differently because higher rates can widen bank net interest margins and lift financial profits, while raising funding costs for indebted companies. Robert J. Shiller at Yale University has written about how low long-term interest rates can be associated with elevated price-earnings ratios and increased vulnerability to speculative bubbles, underscoring the behavioral and cyclical dimensions of rate-driven valuation shifts.

Geography and market structure matter too. Emerging market equities tend to be more volatile when advanced-economy rates rise, as capital flows can reverse and currencies depreciate, deepening earnings pressures. Economies with bank-centered financing, such as Japan, experience different transmission dynamics than market-based systems, affecting how corporate borrowing costs change. Social consequences include wealth effects that alter consumer spending and distributional impacts, since equity ownership is uneven across populations and cultures.

Overall, interest rate changes affect stock valuations through a combination of valuation mechanics and real economic effects. Investors and policymakers monitor both the discount-rate channel and the cash-flow channel to assess whether price adjustments reflect fundamental value shifts or are driven primarily by changes in monetary conditions.