Will interest rate cuts put a rocket up growth stocks?

The RBA may have kept rates steady today but interest rates are still expected to fall in coming months. This is a big positive not only for income stocks but for growth stocks as well. Here's why.

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The market got ahead of itself today and the lack of an interest rate cut took the wind out of it and sent the Australian dollar soaring.

You'd expect that reaction for the dollar and for a fall in high-yielding stocks but the sell down in equities was also felt amongst growth stocks, or stocks that don't attract income investors.

You can see that in blood products supplier CSL Limited (ASX: CSL), media conglomerate News Corp (ASX: NWS) and logistics company Brambles Limited (ASX: BXB).

These stocks fell between 0.5 and 1 percentage point just after the Reserve Bank of Australia (RBA) announced its decision to keep rates steady at 2.25% at 2.30pm.

The rate reaction from growth stocks shouldn't be lost on investors as it has implications for any equity portfolio.

Sure, some would say that the growth stocks I listed are negatively impacted by the jump in the Australian dollar given that these companies have significant foreign currency earnings.

But a similar magnitude drop in the S&P/ASX Small Ordinaries Index (INDEX: ^AXSO) (ASX: XSO) tells you the rate decision impact goes beyond currency translations because most small-cap stocks do not have offshore operations.

Regardless of what kind of stocks we are talking about, the valuation of such securities is materially influenced by bond yields, which in turn are affected by the RBA's cash rate.

For instance, if I lowered the interest rate benchmark used in my discounted cash flow (DCF) valuation by half a percentage point, the price target on a stock (with no or little debt) jumps by about 10%. Debt is deducted from a firm's intrinsic value so highly geared stocks are less affected by changes to the discount rate.

While the RBA didn't cut rates today, it clearly still has an easing bias and many economists are still calling for two rate cuts that'll see interest rates fall to 1.75% from 2.25%.

In light of the equity valuation sensitivity in this falling interest rate environment, you should resist the temptation to only focus on income-stocks because growth stocks also can benefit significantly from falling rates.

However, income stocks are more affected in the short run by rates as lower term deposit returns from interest rate cuts make their yield more appealing.

Also, the benchmark interest rates (called discount rate) used in DCF calculations are tied to long-term government bond yields, which are typically less influenced by changes to the cash rate.

Nonetheless, the RBA's easing bias does put downward pressure even at the long-end of the bond market with the 10-year yield giving up a few basis points this afternoon to trade at 2.27%, which is 36 basis points below where it was last month.

It may just turn out that cutting 0.5% off the discount rate for equity valuation is too conservative. This means stocks could perform far better than most expect.

Motley Fool contributor Brendon Lau owns shares in CSL. Follow me on Twitter - https://twitter.com/brenlau We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policyThis article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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