This article explains how Interest rates affect share price of High leverage stocks in a profound way. This also applys to your Home loan.
Suppose I has Rs. 100, & I started business taking a loan of Rs. 1000 (D/E =10:1). Interest rate is 10% PA, If my profit is Rs. 100/- per annum on my total Investment, my Net profit is Rs. 0 /- . (Earnings- Rs.100/-, Interest- Rs.100/- ; Net profit (PBT) = 0)
If the interest rate comes down to Rs. 9.5%, the Net profit will be Rs. 5 as per the above calculations.
This Net present value of This Rs.5 profit over a 25 year period is @ 9.5% interest rate over a 20 year period is Rs.45. So My Rs. 100 equity value becomes Rs. 145 with a 0.5% reduction in interest rates.
This , analogy apply best for your home loan too. People buys a home with about 90% of debt. Not that , as it seems Indian Interest rates have peaked, it may be time to take high leverage.
This may well mean that stocks with real D/E of about 1:10 , Like Indian Infrasturcture stocks, will appreciate typically by 40-45% for every 0.5% reduction in Interest rates.
Let us take a major infrastructure player in the market - GMR INFRASTRUCTURE . The stock has actual D/E of 5:1, real D/E of more than 10:1 . This is because, the invesments are mostly made in the SPV route. The parent company will have an Debt and equity component. It will again invest in Individual projects , which are treated as separate business, which will further have D/E of about 70:30.
Let us look at the share price of typical infrastructure stock GMR INFRASTRUCTURE over the last 3 years,
| Change Date | RBI REPO RATE | GMR INFRA STOCK PRICE |
| March 19 2013 | 7.500 % | 22 |
| January 29 2013 | 7.750 % | 19.8 |
| April 17 2012 | 8.000 % | 21 |
| October 25 2011 | 8.500 % | 18.75 |
| September 16 2011 | 8.250 % | 25.9 |
| July 26 2011 | 8.000 % | 26.5 |
| June 16 2011 | 7.500 % | 29.8 |
| May 03 2011 | 7.250 % | 34.25 |
| March 17 2011 | 6.750 % | 37.45 |
| January 25 2011 | 6.500 % | 39.4 |
| December 1 2010 | 6.250 % | 43.7 |
| October 1 2010 | 6.000 % | 53.6 |
| October 1 2010 | 6.000 % | 53.6 |
| August 1 2010 | 5.500 % | 63 |
| July 1 2010 | 5.000 % | 55 |
This leaves us , with strong proof that the stock has correlation with Interest rates. Every 0.5 to 1% increase in interest rate - is reflected as about 50% increase in the stock price, Every 0.5 to1% decrease in Interest rate gave about -33% decrease in Stock price.
So in the current macro economic trend, where interest rates are slated to come down , The typical Infrastructure stocks are bound to increase. D/E ratio of 5:1 - The rate of increase will be atleast 50% for every 1% decrease in interest rates. So , come on now and buy the infra names. Its right time to buy.
In the next blog , we will analyze when to invest in the real estate with debt, It is another leverage play that depends on Interest rates purely.
