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Are your dividend stocks at risk of rising interest rates?

Analysts at investment firm Morgan Stanley have found the ‘target prices’ of shares in some of Australia’s favourite infrastructure and energy companies could be at risk if interest rates rise, according to a Fairfax article published today.

Many analysts often set 12-month price ‘targets’ on stocks, which clients can then use to determine whether now is, or isn’t, a good time to buy. Let it be known, however, these targets are almost always wrong.

To arrive at a price target, analysts will conduct rigorous qualitative research to understand the business (including meeting with management, going to production sites and talking to customers). They then create forecasts for future revenue, profit and dividend growth.

However a major point of contention amongst analysts and financial commentators is what is known as the ‘discount rate’.

Discount rates are affected by interest rates because somewhere along the line, someone said investors should demand a greater return from share market investments because the sharemarket is riskier.

The problem is, when interest rates rise, so too does the discount rate. Higher discount rates lead to lower price targets. This occurs because the discount rate enables analysts to adjust for added risk or uncertainty in their forecasts.

For example, analysts valuing troubled iron ore miner Fortescue Metals Group Limited (ASX: FMG) would use a higher discount rate than if they were valuing Wesfarmers Ltd (ASX: WES) – the owner of Coles supermarkets and Bunnings Warehouse – because Fortescue is perceived as a much riskier investment.

What the report found…

According to the Fairfax article, higher interest rates have another adverse effect on popular dividend stock valuations. Just like a mortgagee, if interest rates rise, the price of their debt increases. More debt equals more risk, according to some valuation models.

The report found Auckland International Airport Ltd (ASX: AIA), Transurban Group (ASX: TCL) and Sydney Airport Holdings Ltd (ASX: SYD) were the most sensitive to a 0.5% chance in discount rate. Their price targets would fall 8%, 8.2% and 7%, respectively, if the discount rate went up.

Conversely, if the discount rate dropped, the three companies’ price targets would increase 21%, 18.8% and 18.2%, respectively.

But wait! – There’s more…

In addition to the above, it’s important to consider where the debt comes from. Many of the infrastructure stocks listed on the ASX have debts which are denominated in U.S. dollars. Remember a falling Australian dollar (against the greenback) makes their debt more expensive and more onerous to service. Earlier this week, Fortescue was (embarrassingly) unable to raise money through U.S. bond markets because investors wanted a higher interest rate than it was prepared to offer on its new debt.

Well done for making it this far

After reading through the above, it’s easy to see why so many people choose to leave their share market investments up to the ‘experts’. However, let me tell you, it doesn’t need to be that difficult.

In fact anyone can – and should – conduct their own qualitative research by reading annual reports and conducting visits to sites, stores or factories. The qualitative research is, in my opinion, the really important stuff because all valuations prove wrong over time anyway.

The world’s best investor – Warren Buffett – has taught us that you should never buy shares in a company you don’t understand. It’s one of the great teachings Buffett has passed down to budding long-term investors.

So if own shares in one of the above companies, ask yourself how well you know the company and how it makes its money. Then honestly ask yourself if you’d still be comfortable holding it if its share price dropped 50% tomorrow.

Finally, ask yourself this: If you’re investing for 10 years or more – what does it matter if an analyst changes his or her 12-month price target?

Whilst I’ll agree it’s important to keep a watch on debt repayments, frankly, as a long-term investor, I couldn’t care less where analysts’ 12-month price targets head from here.

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Motley Fool Contributor Owen Raszkiewicz does not have a financial interest in any of the mentioned companies. Owen welcomes your feedback on Google plus (see below) or you can follow him on Twitter @ASXinvest.

The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.  This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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