The S&P 500 Bull Market Plus High Interest Rates Equals Opportunity for 1 Magnificent Stock | The Motley Fool (2024)

The S&P 500 index just set a new all-time high, which means the recovery that began 15 months ago can officially be called a bull market. Investors have been encouraged by the drop in inflation over the past year, which is feeding expectations that interest rates could fall throughout 2024.

Interactive Brokers (IBKR -1.47%) is one of the world's leading online platforms for trading stocks and other financial assets. It benefits from bullish stock market conditions in more ways than one, and it has also experienced a serious financial tailwind from higher interest rates lately. In fact, even if rates do come down slightly, the company's interest income should remain elevated.

But here's the best part: Interactive just reported its official financial results for 2023, and its stock is dirt cheap based on its earnings per share. Here's why investors might want to buy in now.

A soaring stock market is great for Interactive Brokers

The S&P 500 index fell more than 20% from its all-time high at the beginning of 2022, which triggered a bear market. Those conditions can lead to high trading volumes as investors adjust their portfolios, which is typically good for Interactive Brokers, because it earns commissions every time a client completes a transaction in stocks, bonds, options, futures, and other financial assets.

However, a drastic fall in the stock market impacts Interactive's client equity, which is the total value of all cash and assets held on its platform. Commissions are typically calculated based on the value of a transaction, so when client equity is down, transaction sizes tend to be smaller, which means less revenue for the broker. The reverse is also true -- bull market conditions and higher stock prices organically lift client equity.

Considering the S&P 500 ended 2023 with a monster rally, it's no surprise Interactive's client equity soared 39% year over year to $426 billion. It was just $306 billion at the end of 2022, when the was near its low point. The company also saw a 14% increase in margin loans at the end of 2023, which is a clear sign investors are comfortable taking more risk.

New bull markets also attract media coverage, which makes people curious about buying stocks. As a result, Interactive's total client accounts also rose 23% to an all-time high of 2.56 million.

Overall, the improved conditions drove Interactive's non-interest income to $1.5 billion in 2023 (which includes commissions and fees for services), a 10.5% increase compared to 2022. Stock trading volumes were down for the year as 2022 was far more volatile, as I touched on earlier. But investors increased their bets on the market using instruments like options and futures contracts, which was another sign of an increasing risk appetite.

Interest income was the bright spot last year

The stock market decline in 2022 was driven in-part by the U.S. Federal Reserve increasing interest rates to tame inflation, which had soared to multi-decade highs. Investors were concerned those conditions would hurt consumer spending and, therefore, corporate earnings.

But high interest rates are great for Interactive Brokers because it earns interest income in two main ways:

1. It stores customer deposits in bank accounts that pay interest. It passes on some of that income to its customers to entice them to leave money in their accounts, which makes them more likely to transact.
2. It earns interest income when it lends money to clients to buy stocks and other financial assets (margin lending).

Overall, Interactive had a net interest margin (NIM) of 2.36% in 2023, which was up substantially from 1.53% in 2022. The NIM is the difference between what the company earns on the above interest-bearing assets, and what it pays back to customers and to institutions it borrows money from.

It resulted in $2.8 billion in net interest income, marking an increase of 67% year over year.

Interactive Brokers stock is extremely cheap right now

The increase in NIM and net interest income was a massive tailwind to Interactive's earnings (profit) in 2023, because it's highly scalable. In other words, the company doesn't really incur any additional expenses when NIM rises, so most of the proceeds flow straight to its bottom line.

Interactive ended 2023 with $5.67 in earnings per share, up 51% from 2022. Based on its recent stock price around $91, it trades at a price to earnings (P/E) ratio of roughly 16. For context, the S&P 500 index has an overall P/E ratio of 21.5, and Interactive's own five-year average is just a little higher, around 22, according to data from S&P Global Market Intelligence. So if Interactive's stock traded in line with those benchmarks, that implies 33% upside from today's prices.

However, given the steep decline in inflation over the last 12 months, Wall Street thinks the Fed will cut interest rates six times in 2023. That would bring the benchmark federal funds rate down to 4% (from 5.5% today), and while it could dent Interactive's interest income, there would still be enough meat on the bone to maintain a respectable NIM.

Falling rates will become a serious problem if (for example) they return to historic pandemic-era lows near 0.25% on the federal funds rate, which leaves no margin for the company to make money.

On that note, Wall Street is forecasting a modest increase in Interactive's revenue and earnings in 2024, building on its spectacular 2023 results. The new bull market should drive further growth in client equity both organically and by attracting new investors. With that in mind, now might be a great time to buy Interactive stock given its valuation.