Why the rising interest rate concern is hitting tech stocks hardest?
BACKGROUND/ THE WHAT
It has to do with the way Wall Street values stocks. The market is a discounting mechanism: It is a way of trying to figure out what a future stream of cash flow — or earnings — is worth today.
This model, known as the Discounted Cash Flow model, is at the heart of the problem for technology stocks.
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MECHANISM/ THE HOW
Stocks compete with other investments like bonds and cash. If you have $100 now, is it better to invest in stocks, bonds, cash or something else? Investors look at the time value of money. The sooner you own money, the sooner you can invest it. If I have $100 right now, and I can invest it and receive 2% today in a bond, that means I will have $102 next year. A hundred dollars a year from now doesn’t help me, because I can’t invest it.
Second, you have to make a guess on the discount rate. Simply put, what is the opportunity cost of owning alternative investments? That would be the minimum required rate of return you would accept. Usually, it is the prevailing interest rate.
An example
Here’s a greatly simplified example. Suppose you have XYZ company that is generating $1 million in cash this year and is expected to generate the same $1 million in cash flow growth every year for the next five years:
XYZ: Cash flow projections
$5 million cash flow, 5 years
(present value)
- 2% interest: $4.71 million
- 4% interest: $4.45 million
- 6% interest: $4.21 million
The higher rates go, the lower the present value of that future stream of earnings.
$5 million cash flow, 5 years
(present value, 10% growth)
- 2% interest: $6.30 million
- 4% interest: $5.93 million
- 6% interest: $5.59 million
This is an even bigger decline, on a dollar and percentage basis than when there was no growth in cash flow.
THE TAKEAWAY
“Companies relying on future cash flow growth experience much greater risk as rates rise, and that has been the part of the market that has really driven returns in the stock market,” he said. “That is why some parts of the market, like the Nasdaq 100, which is heavy in technology stocks, is getting hit much more than the Dow Jones Industrial Average, which has less companies expecting outsized growth.”
The bottom line, Tchir says, is that bonds are competing with stocks as an investment, and bonds are starting to become more attractive: “If interest rates keep going up, I can make more investing in 10 year Treasurys than I could a week ago, and that makes other investments look less attractive.”
REAL-LIFE EXAMPLE
- Finance Sector (ticker: XLF) vs bond yields
