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S&P 500 Adjusted for Discount Rates

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Written By
Dan Buckley
Contributor Image
Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.
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Updated
Jul 24, 2023

The S&P 500 is a benchmark index, comprising 500 of the largest US publicly traded companies.

It represents the performance of the stock market by reporting the risks and returns of the biggest companies.

Investors use it as the benchmark of the overall market, to which all other investments are compared.

Below we’ll look at the concept of the S&P 500 Adjusted for Discount Rates.

 

Key Takeaways – S&P 500 Adjusted for Discount Rates

  • The S&P 500 is a benchmark index comprising 500 of the largest US publicly traded companies, representing the performance of the stock market as a whole.
  • Discount rates are important in determining the present value of future cash flows and are used to calculate the worth of future profits in today’s terms.
  • Adjusting the S&P 500 adjusted for discount rates provides investors with a clearer picture of the index’s long-term profitability.
  • It’s best suited for long-term investors who care most about the long-term earning potential of their investments.

 

The Concept of Discount Rates

Discount rates are a key component of the time value of money principle.

They are used to determine the present value of future cash flows.

In other words, the discount rate is used to calculate how much future profits are worth today.

Higher discount rates decrease the present value of future cash flows.

 

Adjusting the S&P 500 Performance for Discount Rates

When assessing the performance of the S&P 500, or any investment for that matter, adjusting for discount rates can be an interesting exercise.

By and large, stocks are valued based on two things:

  • earnings, and
  • discount rates

Stocks can be considered as a stream of future earnings, or cash flows.

This stream of earnings should be discounted back to the present to understand the current value of the investment.

If the discount rate increases, it reduces the present value of these future earnings, which can cause the perceived value of the stock to decrease.

Example

Let’s say you own a dividend portfolio that you use for income. Say it earns you $5,000 per month.

As long as the companies stay in good shape, you continue to get that $5,000 per month no matter what the discount rates do to affect the present value of the securities (i.e., their prices).

For someone focused on the long run, if the stocks fall, they probably don’t care all that much and are much more interested in the profit-earning potential of the business.

This mindset would also be mirrored by a landlord focused on their net rental income rather than what the home’s value is doing if they have no intention of selling.

It would also be seen by a private business owner who is focused on the profit-making capacity of the business and doesn’t have the business marked to market.

Longer-term investors are those who would be most interested in such a metric.

 

How Discount Rates Affect Stock Performance

Higher discount rates can make stocks appear less attractive because a higher discount rate reduces the present value of the future earnings stream that a stock represents.

In other words, even if a company’s earnings projections remain unchanged, an increase in the discount rate can cause the stock price to fall.

Earnings/earnings expectations can also rise, but stocks can fall if the discount rate rises by more than that.

An example would be the S&P 500 in 2022. It lost about 18% that year, but it was up after adjusting for discount rates (by about 5%) when taking into account the long-term earnings expectations.

This is because the future earnings are now worth less in today’s dollars.

 

S&P 500 and Long-Term Profit Outlook

When it comes to assessing the long-term performance of the S&P 500, adjusting for discount rates provides a clearer picture of the index’s performance in terms of earnings.

This is because this approach recognizes that stocks represent a claim on a long-term stream of future earnings.

By adjusting for discount rates, investors can get a better sense of the underlying profitability of the companies that make up the index.

 

Conclusion – S&P 500 Adjusted for Discount Rates

Adjusting the S&P 500 performance for discount rates provides a different view of the index’s performance by showing the long-term profitability of its constituent companies.

It allows investors to account for the time value of money when assessing the value of the S&P 500 and individual stocks.