When the price of borrowing money changes, the mathematical value of future earnings changes with it — even when those earnings haven’t changed at all. That’s why rising interest rates send stock prices lower, sometimes dramatically, without any deterioration in the underlying businesses.
In 2022, the Federal Reserve raised interest rates faster than at any point in forty years — from near zero to over four percent in less than twelve months. Many technology companies saw their stock prices fall 60, 70, even 80 percent over the same period.
Many of those same companies were still growing. Still adding customers, expanding revenues, reporting quarterly results that were ahead of the year before. Nothing fundamental had broken inside the businesses.
The prices fell anyway.
This is not a mystery if you understand what interest rates actually do to the mathematics of valuation. Once you see it clearly, the 2022 repricing — and every similar rate-driven move that has occurred throughout market history — stops looking like chaos and starts looking like arithmetic.
A Dollar in the Future Is Worth Less Today
Before we get to interest rates and stock prices, there’s one idea you need clearly in mind: present value.
Here’s a simple question: would you rather have $1,000 today, or $1,000 five years from now?
Almost everyone would take the money today. That’s not impatience — it’s logic. $1,000 you hold right now can be invested. At six percent per year, it becomes roughly $1,338 in five years. So $1,000 today is worth more than $1,000 in the future, because the money you hold now has time to compound.
This means that future money, measured in today’s dollars, is worth less than its face amount. How much less depends on two things: how far away the future payment is, and what rate of return you can earn on money you hold today.
That rate — the one you use to translate a future amount back into today’s dollars — is called the discount rate. Plug it into the formula:
Present Value = Future Amount ÷ (1 + Discount Rate)^YearsConsider a simple example. A business promises to pay you $1,000 five years from now.
- At a 5% discount rate: Present Value = $1,000 ÷ (1.05)⁵ ≈ $784
- At a 10% discount rate: Present Value = $1,000 ÷ (1.10)⁵ ≈ $621
The future payment is identical. The business is identical. But when the discount rate rises from 5% to 10%, the present value of that future payment drops from $784 to $621 — more than a 20% decline.
That relationship is everything: discount rate up, present value down. Keep it in mind as we continue.
Stocks Are Claims on Future Earnings
A share of stock is not just a number on a screen. It’s a legal claim on the future earnings of a real business — every dollar the company will generate for its owners over the next ten, twenty, or thirty years.
To determine what that stream of future earnings is worth today, investors discount each future payment back to present value using a rate that reflects two things:
- The risk-free rate — the return available on the safest possible investment. In the United States, that anchor is typically a U.S. Treasury bond, backed by the full faith and credit of the federal government.
- A risk premium — the additional return that investors require to justify buying stocks instead of the safer Treasury bond. Stocks are riskier. Earnings can fall. Companies can fail. The risk premium compensates for that uncertainty.
Add the two together and you get the discount rate used to value the business.
When Treasury rates are low — near zero, as they were in 2020 and 2021 — the full discount rate is low. Future earnings are worth a lot in today’s dollars. Stock prices are high.
When Treasury rates are high — four, five, six percent — the full discount rate is high. Those same future earnings are worth less in today’s dollars. Stock prices are lower.
This is not a soft, approximate relationship. It’s math. Every dollar the company expects to earn in 2028, 2031, or 2035 is discounted back to today using that rate. When the rate rises, the present value of each of those future dollars falls — even if the future dollar amounts haven’t changed at all.
That is the mechanism. That is why stock prices move when interest rates move.
Why Growth Stocks Feel It More
Not all companies are equally sensitive to interest rate changes. The key is when most of a company’s earnings are expected to arrive.
Imagine a utility company — one that provides electricity to a region, earns stable and predictable revenue year after year, and pays a steady dividend. Most of the value an investor receives from that company comes relatively soon: this year’s dividend, next year’s, the year after that. The earnings are near in time.
Now imagine a high-growth technology company — one that is currently reinvesting almost all of its revenue into expanding its operations, and whose really large earnings are expected to arrive five, ten, or fifteen years in the future, once the growth has compounded.
When interest rates rise, both companies’ future earnings get discounted at a higher rate. But for the technology company, the damage is larger. The earnings that are furthest away get discounted the most — because they have to travel further to reach today, and the compounding effect of a higher rate has more years to work against them.
This concept has a name borrowed from the bond market: duration. In bonds, duration measures how sensitive a bond’s price is to changes in interest rates: long-duration bonds (those with far-off maturity dates) are more sensitive than short-duration bonds. Stocks work the same way.
A company whose value is concentrated in near-term earnings — low duration — barely feels a one-percentage-point rise in rates.
A company whose value lies mostly in earnings fifteen years out — high duration — can lose 30 or 40 percent of its calculated fair value from the same one-percentage-point rise.
This is exactly what happened in 2022. Many of the technology companies that fell the furthest were precisely the ones whose entire investment case was built on earnings still years in the future. The businesses hadn’t failed. The duration math had simply caught up with them when rates moved.
The Fed’s Role — and Why Expectations Move First
The Federal Reserve — commonly called the Fed — is the central bank of the United States. Among its responsibilities is setting the federal funds rate: the interest rate at which banks lend money to each other overnight. That rate is the root of the system. Changes in it ripple outward — into mortgage rates, corporate borrowing costs, and ultimately the risk-free rate that investors use when discounting future stock earnings.
Here is something that surprises most people new to investing: markets don’t wait for the Fed to actually move.
The stock market reacts to expectations of future rate changes. When Federal Reserve officials signal, through speeches or policy statements, that they expect to raise rates in the coming months, investors immediately begin discounting future earnings at a higher rate. The adjustment in stock valuations happens before the rate hike does.
This is why the market sometimes seems to react strangely. An announcement that the Fed is raising rates — but by less than investors had expected — can cause stock prices to rise. Not because conditions improved, but because the future discount rate came in below what had already been priced in.
Similarly, when economic data weakens and investors begin expecting the Fed to cut rates in the future, stock prices tend to rise in anticipation. Lower expected future discount rates mean higher present values of future earnings — and markets reprice immediately, not when the cuts actually arrive.
The practical conclusion for an investor: by the time you read a headline announcing a rate decision, the stock market has already moved on it — usually months earlier, when the expectations shifted.
The Same Business, Two Different Prices
To make this concrete, consider how much the math can shift even in a simplified example.
Imagine a business you estimate will earn $50 per share per year, on average, over the next ten years. (Real valuation models are more detailed than this, but the logic holds for illustrative purposes.)
At a 5% discount rate — the kind of environment that existed in 2020 and 2021 — the present value of ten years of $50 annual earnings comes to roughly $386 per share.
At an 8% discount rate — closer to what a higher-rate environment implies — the present value of those same earnings falls to roughly $336 per share.
The business didn’t change. The earnings didn’t change. The implied fair value fell by about 13 percent purely because the discount rate moved.
Now extend the same logic to a growth company most of whose earnings lie further in the future — years 8 through 20 rather than years 1 through 10. Those more distant cash flows are discounted far more heavily, and the percentage decline in present value from a rate increase is substantially larger.
This is why the same business can be fairly priced in one interest rate environment and meaningfully overvalued in another — with no change in the business itself.
An investor who understands this can ask the right question when prices fall during a rate-rising period: did the business change, or did the discount rate change? If only the discount rate changed, the investor has a basis for estimating how much of the price decline is simply the math working itself out — and whether the new price is closer to or further from fair value.
What This Means in Practice
You do not need to forecast interest rates to invest successfully. Professional investors who try to do this for a living are mostly wrong, and often spectacularly so.
What you do need is the discipline to separate two questions when prices are falling:
Question 1: Did the business change? Did revenues slow, margins compress, competitive position weaken, or management make a significant error?
Question 2: Did the discount rate change? Did interest rates rise in a way that mathematically reduces the present value of future earnings — even for businesses that are performing exactly as expected?
If the answer to Question 1 is yes, that’s important information. The investment case may have changed.
If the answer to Question 2 is yes but Question 1 is no — if the business is performing fine but the price fell because rates rose — that’s a very different situation. It means the asset became cheaper without becoming less valuable. That’s often where the best opportunities appear for patient investors.
A Note to Luca and Lili
You will watch stock prices fall sharply during your investing lives. Some of those declines will coincide with rising interest rates, and everything around you — financial news, conversations with people you respect, the collective mood of the market — will make it feel like something has gone wrong.
The thing to hold onto is the question: which kind of decline is this?
Is the business genuinely deteriorating? Or is this a rate-driven repricing — the math of higher discount rates working through the present values of future earnings, pulling prices down even though the businesses are performing exactly as expected?
Those two kinds of declines look identical in a brokerage account. They feel the same emotionally. But they call for completely different responses.
The discipline to ask that question — calmly, using the framework rather than reacting to the price — is one of the most valuable things you can develop. It takes practice to build and patience to apply when everything feels urgent. But it is the difference between an investor who responds rationally to information and one who responds emotionally to noise.
Be the former.
— Papa
The One-Paragraph Summary
Interest rates move stock prices because they change the discount rate used to translate future earnings into present value: when rates rise, the discount rate rises, and the present value of every future dollar of earnings falls — even if those earnings themselves haven’t changed. The sensitivity is not equal across all companies: long-duration businesses, whose most important earnings lie far in the future (typically high-growth companies still in an expansion phase), are far more sensitive to rate changes than short-duration businesses, whose value is concentrated in near-term cash flows. The Federal Reserve sets the anchor of this system through the federal funds rate, but markets react primarily to expectations of future rate moves — adjusting stock prices months before the Fed actually acts. The practical skill for an investor is the ability to separate price declines caused by genuine business deterioration from price declines caused by the arithmetic of a higher discount rate — the same business, performing the same way, but worth less in present-value terms at a higher rate. Getting that distinction right is at the heart of rational investing in any rate environment.
Next: Part 3 — Inflation: What It Does to Real Returns. Inflation erodes what a future dollar can actually buy — which means that the earnings a business reports may overstate what its owners actually gained in real, purchasing-power terms. Part 3 explains why inflation affects some businesses far more than others, and how to adjust your thinking when prices are rising.
— Jim