Why this rate-based sale affects technology stocks the hardest

What is behind the decline in technology stocks? A model that Wall Street uses to evaluate stocks is a flash of attention.

The technical actions are being corrected. The Nasdaq 100, the 100 largest non-financial stock on the Nasdaq, has a 10% discount from its all-time high just three weeks ago, but many big names are close to 20%.

Technique in correction
(% from 52 weeks maximum)

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

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

Why would rising interest rates affect stocks, especially stocks with flight technology?

It has to do with how Wall Street values ​​stocks. The market is a mechanism of reduction: it is a way of trying to figure out what a future cash flow – or gain – is worth today.

This model, known as the Cash Flow Discounted model, is at the heart of the technology inventory problem.

Shares compete with other investments, such as bonds and cash. If you have $ 100 now, is it better to invest in stocks, bonds, cash or something else? Investors analyze the amount of time money. The faster you have money, the faster you can invest it. If I now have $ 100 and 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 on doesn’t help me, because I can’t invest it.

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

What is the value of a dollar invested today in a stock that you might want to hold, say, for five years? Most stocks are valued based on how much money they can generate in the future. The discounted cash flow uses a formula to determine the present value of an expected future cash flow.

It is not an easy thing to figure out. The first thing you need to do is find out how much cash flow the company could generate, say a year from now.

The problem is that no one knows exactly how much money a company will generate in a year from now. It depends on many factors, including economics, management, competition and the nature of the business. The further you go, the harder it gets. It is much more difficult to estimate cash flow over five years, then over a year.

Second, you need to guess the discount rate. Quite simply, what is the opportunity cost of owning alternative investments? This would be the minimum required rate of return that you would accept. Usually, the interest rate is predominant.

Finally, reduce the expected cash flows.

Here is a much simplified example. Suppose you have an XYZ company that generates $ 1 million in cash this year and expects to generate the same $ 1 million increase in cash flow each year for the next five years:

XYZ: cash flow projections

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

Total cash flow over five years: $ 5 million

You have $ 5 million in cash flows. But wait: that’s $ 5 million over 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, or even a year from now.

So we need to cut what will be the next million dollars into current dollars. To do this, we need to make an estimate of interest rates.

Suppose the interest rates are 2%.

Using a complex formula, the discounted cash flow of $ 5 million would be considerably lower, say $ 4.71 million. In other words, when we assume 2% interest, the value of that $ 5 million cash flow – the current value – is $ 4.71 million.

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

Suppose the rates range from 2% to 4% or even 6%. The discounted cash flow – the discounted value – of the $ 5 million would decrease:

$ 5 million cash flow, 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 that future revenue stream.

It gets even worse when you’re dealing with high-growth stocks, such as many tech stocks.

This is because many stocks of technology have incorporated rapid growth assumptions. Instead of cash flows that would always be $ 1 million a year, for example, many would have growth expectations of 10%, 20%, 30% or more.

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

Suppose the company increases its cash flow by 10% per year for five years. Assuming an interest rate of 2%, the current value after five years would be about $ 6.30 million, but change the interest rate to 4% or 6%, and the numbers decrease:

$ 5 million cash flow, 5 years
(discounted value, 10% increase)

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

This is an even greater decline, based on the dollar and the percentage, than when there was no increase in cash flow.

Peter Tchir from the Academy of Securities told me that this is the essence of the problem: higher rates lower the current value of the expected cash flow and this means that investors will seek to pay less for a share.

“Companies that rely on future cash flow growth have a much higher risk as rates rise, and it was the market share that really led to returns to the stock market,” he said. “That’s why some parts of the market, like the Nasdaq 100, which has a large amount of technology stocks, is much larger than the Dow Jones industrial average, which has fewer companies expecting excessive growth.”

The conclusion, says 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 invest more in the 10-year Treasury than I could a week ago, and that makes other investments to look less attractive. “