Why is this rate-driven rate sale affecting technology stocks the most?

What is behind the fall in technology stocks? A model that Wall Street uses to value stocks is a dazzling precaution.

Technology actions are in order. The Nasdaq 100, the Nasdaq’s 100 largest non-financial stocks, has a 10% discount on the all-time high it reached just three weeks ago, but many big names are down close to 20%.

Technology in correction
(% of maximum of 52 weeks)

• Xilinx 23%
• PayPal 22%
• 21% AMD
• Nvidia 19%
• Apple 17%

What is happening? The market is worried that interest rates will skyrocket and that the Federal Reserve will not be able to control it.

Why would a rise in interest rates affect stocks, particularly high-flying technology stocks?

It has to do with how Wall Street values ​​stocks. The market is a discount mechanism: it is a way of trying to find out what a future cash flow (or profit) is worth today.

This model, known as the discounted cash flow model, is at the heart of the problem of technology stocks.

Shares compete with other investments, such as bonds and cash. If you now have $ 100, is it better to invest in stocks, bonds, cash or something else? Investors analyze the time value of money. The sooner you have money, the sooner you can invest it. If I have $ 100 right now and I can invest them and receive 2% today in a bond, that means I will have $ 102 next year. One hundred dollars a year from now on doesn’t help me, because I can’t invest them.

What does this tell us? He tells us that today a dollar is worth more than a dollar in the future because that $ 100 has become $ 102 if I invest in a bond.

What’s a dollar invested today in a stock you might want to hold for, say, five years? Most stocks are valued based on how much cash they can generate in the future. The discounted cash flow uses a formula to find out the current value of an expected flow of future cash flows.

This is not easy to understand. The first thing you need to do is find out how much cash flows your company can generate, for example, in a year’s time.

The problem is that no one knows exactly how much money a company will generate in a year. It depends on many factors, including economics, management, competition, and the nature of the business. The farther it goes, the harder it becomes. It is much harder to estimate cash flow five years after a year out.

Second, you need to make a guess about the discount rate. Simply put, what is the opportunity cost of having alternative investments? This would be the minimum return rate you would accept. It is usually the predominant interest rate.

Finally, discount expected cash flows to date.

Here is a very simplified example. Suppose you have an XYZ company that will generate $ 1 million in cash this year and expect to generate the same $ 1 million growth each year over the next five years:

XYZ: cash flow projections

• Year 1: $ 1 million
• 2nd year: $ 1 million
• Year 3: $ 1 million
• Year 4: $ 1 million
• Year 5: $ 1 million

Total cash flow in five years: $ 5 million

You have $ 5 million in cash flows. But wait: that’s $ 5 million in five years. Is it really worth $ 5 million today?

It’s not, because inflation erodes the value of money: $ 1 million in five years isn’t worth as much as it is today, not even in a year.

So we have to discount what will be the future of a million dollars in current dollars. To do this, we need to make an assumption about interest rates.

Let’s say interest rates are 2%.

Using a complex formula, the discounted cash flow of that $ 5 million would be considerably lower, say, $ 4.71 million. In other words, when an interest rate of 2% is assumed, the value of this cash flow of $ 5 million (the present value) is $ 4.71 million.

Here’s the problem with rising rates and stocks: as interest rates rise, the current value of those $ 5 million decreases.

Let’s say rates range from 2% to 4%, or even 6%. The discounted cash flow (current value) of this $ 5 million would go down:

Cash flow of $ 5 million, 5 years
(Current value)

• 2% interest: $ 4.71 million
• 4% interest: $ 4.45 million
• 6% interest: $ 4.21 million

The higher the rates, the lower the current value of this future flow of profits.

It gets even worse when it comes to high-growth stocks, like many tech stocks.

This is because many technological actions incorporate rapid growth hypotheses. Instead of cash flows that would always be $ 1 million a year, for example, many would have expectations of growing 10%, 20%, 30% or more.

In this case, an increase in rates would further affect the current value of the investment.

Let’s say the company grows cash flow by 10% annually for five years. Assuming a 2% interest rate, the current value after five years would be about $ 6.30 million, but change the interest rate to 4% or 6% and the numbers go down:

Cash flow of $ 5 million, 5 years
(current value, 10% growth)

• 2% interest: $ 6.30 million
• 4% interest: $ 5.93 million
• 6% interest: $ 5.59 million

This is an even greater decline, in terms of dollars and percentages, than when there was no growth in cash flow.

Peter Tchir of Academy Securities told me that this was the heart of the problem: higher rates reduce the current value of the expected cash flow and this means investors will be looking to pay less for a share.

“Companies that rely on future cash flow growth present a much greater risk as rates rise, and this has been the part of the market that has really generated returns in the stock market,” he said. “That’s why some parts of the market, such as the Nasdaq 100, which has a lot of technology stock, is affecting much more than the Dow Jones industrial average, which has fewer companies expecting excessive growth.”

The conclusion, according to Tchir, is that bonds compete with stocks as an investment and bonds are starting to become more attractive: “If interest rates continue to rise, I can make more investments in ten-year treasuries than I did a year ago. week, and that makes other investments seem less attractive. “