Warren Buffett on why interest rates matter so much for investing

  • Warren Buffett explained the importance of Treasury bond yields in determining stock valuations.
  • "The most important item over time in valuation is obviously interest rates," Buffett said last year. "Any investment is worth all the cash you're going to get out between now and judgment day discounted back."
Warren Buffett
David A. Grogan | CNBC
Warren Buffett

Warren Buffett believes interest rates are critical in determining stock valuations.

The Dow Jones Industrial Average plunged more than 1,300 points in two days as investors worried about the negative effects from the rising interest rate environment.

In a 2017 interview video clip found using CNBC's Warren Buffett Archive, the investor explained why rates matter so much for investors.

"The most important item over time in valuation is obviously interest rates," Buffett said last year. "If interest rates are destined to be at very low levels. … It makes any stream of earnings from investments worth more money."

Investors use U.S. government bond yields as their "risk-free" discount rate in financial models to value stock investments.

"The bogey is always what government bonds yield, you can pick your maturity. And you see it in real estate. Real estate yields adapt quite quickly and fairly directly with interest rates," he added. "It's the same principle [with stocks]."

On Tuesday, the 10-year note yield traded above 3.25 percent, hitting its highest level since 2011. The move occurred about a week after Federal Reserve Chairman Jerome Powell said in an interview with PBS that the central bank is a "long way" from getting rates to neutral, which pointed to a possibly more aggressive path for rate hikes.

The Oracle of Omaha said when interest rates rise to high levels such as more than 15 percent for the 2-year Treasury note in the early 1980s, it makes higher equity valuation multiples much less attractive.

"Any investment is worth all the cash you're going to get out between now and judgment day discounted back. The discounting back is affected by whether you choose interests rates like those of Japan or interest rates like those we had in 1982," he said in 2017. "When we had 15 percent short-term rates in 1982, it was silly to pay 20 times earnings for stocks."