The dirty little secret of the solar industry is that it isn't really driven by environmental concerns or a desire for energy independence, or any of these other concepts people want to tout. The reality is that it's driven by interest rates and the cost of electricity for customers. 

A solar installation, whether it's one solar panel or 1 million solar panels, will be judged on the amount of electricity it can produce over time, how much that electricity is valued, and the present value of all of those cash flows or (in the case of a homeowner) cost savings. It's like installing a bond on your roof. That's why low interest rates could make solar companies that hold solar assets on their balance sheets great buys today. 

Roof with large solar installation.

Image source: Getty Images.

How a residential solar installer works

When an installer like Sunrun (NASDAQ:RUN), Vivint Solar (NYSE:VSLR), or SunPower (NASDAQ:SPWR) sells a solar installation with a lease or power purchase agreement, it finances the project itself. It spends the upfront money to build the system, and in return agrees to receive monthly payments from customers that are either fixed or correspond to the amount of electricity that's produced. 

Installers then sell off pieces of their projects, like tax benefits and future cash flows, to investors, making back some or all of the money they spend on installations. What's left for them is what's known as "estimated net retained value". This is the present value of the cash flows companies expect to keep. 

At the end of the first quarter, Vivint Solar had $2.38 billion in gross retained value and $1.25 billion in net retained value. Sunrun had $3.86 billion in what it calls gross earning assets and $1.60 billion in net earning assets. These are similar measures of the long-term values these companies hold on their balance sheets. SunPower doesn't report retained value in the same way, but after spinning off Maxeon Solar Technologies this summer it will have a similar business to Vivint and Sunrun and may report similar numbers in the future. 

These retained value numbers are critical in how we value solar stocks, and interest rates have a lot to do with that. 

Where interest rates come in

When calculating retained value, companies need to decide on a rate to discount future cash flows. $100 in contracted revenue 10 years from now is worth less than that today, but by how much? 

The higher the rate companies discount future cash flows, the lower the value those future cash flows have. If rates fall, on the other hand, the value goes up. Normally, solar companies have used 6% as their discount rate, but it's possible that's too high today. 

What's changed for solar companies in the last few months is that rates have dropped like a rock in 2020. 

10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

This should allow solar companies to sell tax assets and future cash flows for more than they could at the beginning of the year. And it should lower the rate at which we discount future cash flows. In essence, the value they have on their balance sheets has gone up without their doing anything. 

Solar stocks could have room to run

Solar stocks have been volatile this year but have dropped sharply since their peaks in February. That could be a buying opportunity for long-term investors who see the value companies are now holding on their balance sheets. If low rates last, solar stocks should be among those that thrive when the economy begins to recover.