How Concerned Should You Be About What the Fed Does? Only Minimally.

Few questions occupy Wall Street financiers, Main Street bankers, and the financial media more than what the Federal Reserve will do about interest rates. Federal Reserve Chairman Janet Yellen (pictured at left) and the 11 other members of the Federal Open Market Committee will meet again this coming Sept. 20-21, so get ready for another tsunami of speculation.

As a building material dealer, you no doubt have a much longer perspective than do stock traders, even if you have an M&A deal in the works. Here’s what you should be thinking:

• Right now, our economy is growing at a rate of just under 2.5% annually. This is greatly preferable to the downturn, but it is not a growth scenario under which it is likely that the Fed will be aggressive in raising rates.
• The current consensus prediction for interest rates calls for an increase of two to four percentage points over the next two years.
• Hopefully, the Federal Reserve will take the softest possible posture in raising rates as the economy continues to recover and grow. Barring any crazy developments that would force a change, this low-key approach should prove highly beneficial for profitability and M&A activity over the next several years.

If you ask an economist and a financial analyst how interest rates, the direction of the stock market, and the level of M&A activity are related, they may give you very different answers. Both, however, would likely predict that an increase in interest rates will lead to a drop in stock prices.

To the financial analyst, high rates could hurt a company’s current share price because it reduces the present value of that company’s future cash flows. An economist, meanwhile, views a company’s publicly traded stock price as capturing the value of the future profits of that company and reflecting the supply of and demand for shares. If interest rates increase, the company’s financing and other operating costs will increase, expected future profits will decrease, and a drop in demand for the company’s shares will lead to a share price decrease.

An interest rate increase also can lead to little or no change in the level of stock prices. If, for example, the Fed was clear in signaling that interest rates would likely increase at its next meeting, the market may “price in” such an increase well in advance of the official increase. Thus, the market may only react to the change to the extent that it was different than that which had already been priced into the market.

High stock market valuations are predictors of increased M&A activity. When stock market valuations are high, publicly traded companies use their shares as currency in buying other companies. Such transactions only require board approval rather than the placement of debt or equity capital by external investors. Companies that rely on stock market valuations as comparable indicators of their own value may decide to sell when public equity valuations are high.

However, there is a discount that must be applied to public company’s EBITDA multiples in order to arrive at a comparable valuation level for a privately held company. This discount is generally accepted to be on the order of 30% to 50% percent.

Low or decreasing interest rates are also highly beneficial to M&A activity. When interest rates are low, debt capital is plentiful, and restrictions that lenders place on borrowers are relaxed, it is easier for buyers to fund a greater portion of their acquisitions with debt capital. Since the cost of debt is significantly lower than the required rate of return (effectively, the cost) of equity, a debt heavy acquisition structure makes it easier for buyers to achieve their desired equity returns. They have less capital tied up in the acquisition and, as long as the debt is not dangerously high relative to the possibility of a soft economy in the future, the investment is more likely to be successful.

As debt becomes more expensive or more difficult to secure, buyers are forced to undertake acquisitions with more expensive equity capital. Assuming required rates of return on equity remain the same, buyers should lower their bids for target companies when debt is scarce or expensive.