2. Discounting and present value: why rate rises punish some companies more than others

Macro 1: The price of money

The previous module ended on a sentence that needs unpacking: when the risk-free rate rises, everything gets cheaper even though the businesses have not changed. Now for the exact mechanism, because not everything gets cheaper to the same degree, and the difference explains why in one and the same year some companies fall 60% and others rise 60%.

Discounting is dragging the future into the present

If risk-free money yields 5% a year, then 100 euros today turns into 105 a year from now with no effort at all. Put the other way round: 105 euros a year from now are worth 100 today. That operation of bringing a future amount into the present is called discounting, and the rate you use to do it is the discount rate.

The formula is a single division, and it is worth seeing because everything else follows from it. The value today of a future amount is that amount divided by (1 + rate) raised to the number of years. In concrete numbers, the value today of 100 euros you will receive in:

• 1 year, at 2%, is 98 euros. At 5%, 95 euros. Barely any difference.
• 10 years, at 2%, is 82 euros. At 5%, 61 euros. The gap is already enormous.
• 30 years, at 2%, is 55 euros. At 5%, 23 euros. The same future payment is worth less than half.

Notice the pattern: the further away the money sits, the more a rise in the discount rate destroys it. This is not an opinion or a market mood; it is the arithmetic of the exponent. One year of distance is discounted once; thirty years are discounted thirty times over.

A company is a pile of future payments

The value of a company is, conceptually, the sum of all the money it will hand to its owners from today until the end of time, each amount brought into the present with the division above. From that comes the key consequence of this module.

Imagine two companies worth the same in the market today:

• Company A, mature. It makes money already, and distributes it steadily. Most of its value sits in payments over the next five or ten years. Think of a utility, a tobacco company, an oil major.
• Company B, growth. Today it loses money or earns very little, but it is expected to be enormous in ten or fifteen years. Almost all its value sits in very distant payments. Think of a technology company in its expansion phase, or a biotech with no approved product.

Raise the discount rate from 2% to 5%. Company A gets mostly gentle divisions, because its payments are close at hand. Company B gets the brutal divisions from the 30-year row. Yesterday the two were worth the same and today they are not, and neither has lost a customer. In the jargon, company B is a long-duration asset: its value is concentrated far away in time, and that is why it is hypersensitive to interest rates.

The same year, two opposite worlds

2022 is the perfect natural experiment, because the discount rate moved a long way and fast:

• The Nasdaq, packed with companies whose value lives in the distant future, fell around 33%.
• The energy sector of the S&P 500, packed with companies earning hard cash in that very year, rose close to 60%.
• Funds concentrated in speculative, lossmaking technology shed two thirds of their value.

There were other factors, of course: the war pushed up gas and oil prices, which helps explain the energy side. But the simultaneous collapse of everything promising distant profits, including companies whose sales were still growing, is not explained by the business. It is explained by the denominator.

Why this matters for a strategy, not just for a headline

Three practical consequences follow directly from the above:

• A 'growth companies' screen is, without meaning to be, a bet on interest rates. You may believe you are selecting innovation while in fact buying sensitivity to monetary policy.
• A strategy tested only on data from 2009 to 2021 lived entirely inside a regime of rates falling toward zero. Any tilt toward long-duration assets was rewarded for thirteen years running for a reason that will not repeat itself in the same way.
• The correlation between shares and bonds changes sign depending on where the shock comes from. If the shock is recession, they move in opposite directions and diversification works. If the shock is inflation and rates, they move together and diversification vanishes exactly when you needed it.

The idea to take away is simple to state and hard to internalize: the price of almost everything is a future payment divided by a number, and that number is moved by macro. Once you understand that division, a good deal of what looks like market noise stops looking like it.