Value Companies | Becoming More Valuable
It must have been one of the first few classes of my college macroeconomics course when we learned the term, “opportunity cost.” Simply put, opportunity cost is the alternative benefits you give up by making a choice. For example, this tension is felt when scrolling through the myriad options on Netflix each night. We want to make the most enjoyable choice with our limited amount of time. The fundamental question is, “What am giving up for what I am getting?” On nights when Amber and I have an unusually limited amount of time, we will likely go to an old faithful like “The Office” or “Modern Family.” But on weekend nights, when we have more time on our hands, we will often sample several new films before eventually (hopefully) finding that diamond in the rough.
In the stock market, opportunity cost is the loss you incur on other investments by choosing a different one. As you know, there are many types of companies one can buy. For the sake of simplification, I will stick with two key types: growth and value. Growth companies tend to offer much of their upside in the form of potential profits and growth, in the future. Value companies, however, tend to offer more of their upside through dividends that come from profits being made today.
Economists have determined a formula that takes present actual and future potential profits into consideration when determining a company’s current value. If the present and the future are both taken into consideration when determining the current value of a company, opportunity cost becomes much easier to calculate. This formula, which is widely used by investors, relies heavily on interest rates for its calculation. This is especially important for companies who need to look out into the future for profitability, like many growth companies. The higher interest rates are, the less a company’s potential future profits are worth today, according to the formula.
Simply put, as interest rates rise, investors tend to be less willing to look out to the future for their returns. It is important to note that interest rates, which have been on a somewhat steady decline since 1981, reached crisis era historic lows in 2021. The Federal Reserve has signaled that they are likely to raise interest rates throughout 2022 and even into 2023. Over the last few months we have already seen how just the anticipation of rising interest rates, the present value formula, and opportunity cost have shifted investor portfolio balances toward more value-oriented holdings; companies with profits today.* While it is important to stay diversified, we anticipate that this changing of sentiment from growth to value will continue as interest rates ascend.