Why this interest-driven sell-off is hitting tech stocks the hardest
A Model X is on display at a Tesla showroom in Beijing, China on February 13, 2021.
VCG | Visual China Group | Getty Images
What’s behind the tech stocks decline? One model that Wall Street uses to value stocks is very cautious.
Tech stocks are in correction. The Nasdaq 100, the 100 largest non-financial stocks on the Nasdaq, is 10% below its all-time high three weeks ago, but many big names are down nearly 20%.
Tech in correction
(% of 52-week high)
- Xilinx 23%
- PayPal 22%
- AMD 21%
- Nvidia 19%
- Apple 17%
What’s happening? The market fears that interest rates will skyrocket and the Federal Reserve may not be able to control them.
Why would a rise in interest rates hurt stocks, especially soaring tech stocks?
It has to do with how Wall Street values stocks. The market is a discounting mechanism: it tries to figure 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 for technology stocks.
How DCF works
Stocks compete with other investments like bonds and cash. Now, if you have $ 100, is it better to invest in stocks, bonds, cash, or something else? Investors look at the time value of money. The sooner you have money, the sooner you can invest it. If I have $ 100 now and can invest it today and get 2% on a bond, that means I’ll have $ 102 next year. A hundred dollars a year won’t help me because I can’t invest it.
What does that tell us? It tells us that a dollar today is worth a dollar in the future because that $ 100 has become $ 102 when I invest in a bond.
What is one dollar invested today worth in a stock that you want to hold for five years, for example? Most stocks are valued based on how much cash they can generate in the future. Discounted cash flow uses a formula to find the present value of an expected stream of future cash flows.
It’s not easy to find out. The first thing you need to do is figure out how much cash flow the company could generate, for example in a year.
The problem is, no one knows exactly how much money a company will make in a year. It depends on many factors including the economy, management, competition, and the type of business. The further you go, the harder it gets. It’s much more difficult to estimate cash flow after five years than after one year.
Second, you need to guess the discount rate. Put simply, what is the opportunity cost of owning alternative investments? This would be the minimum rate of return you would accept. Usually it is the prevailing interest rate.
Finally, discount the expected cash flows to date.
Discounted cash flow: an example
Here is a very simplified example. For example, let’s say you have an XYZ company that is generating $ 1 million in cash this year and is projected to have the same cash flow growth of $ 1 million every 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
Five year total cash flow: $ 5 million
You have $ 5 million in cash flow. But wait: that’s $ 5 million over five years. Is it really worth $ 5 million today?
It’s not because inflation is undermining 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 have to settle what this future $ 1 million will be in present dollars. To do this, we need to guess the interest rates.
Suppose the interest rates are 2%.
Using a complex formula, the discounted cash flow of that $ 5 million would be significantly less, say $ 4.71 million. In other words, assuming a 2% interest rate, the value of this $ 5 million cash flow – the present value – is $ 4.71 million.
Here’s the problem with rising rates and stocks: as rates go up, the present value of that $ 5 million goes down.
Let’s say interest rates go up from 2% to 4% or even 6%. The discounted cash flow – the present value – that $ 5 million would go down:
$ 5 million cash flow, 5 years
- 2% interest: $ 4.71 million
- 4% interest: $ 4.45 million
- 6% interest: $ 4.21 million
The higher the interest, the lower the present value of this future income stream.
It gets worse when you’re dealing with high-growth stocks like many technology stocks.
This is because many technology stocks have quick growth assumptions in them. Instead of cash flows that would always be $ 1 million per year, for example, many would expect growth of 10%, 20%, 30%, or more.
In this case, a rise in interest rates would put even more pressure on the present value of the investment.
Let’s say the company has been growing its cash flow by 10% per year for the past five years. Assuming a 2% interest rate, the present value after five years would be approximately $ 6.30 million. However, change the interest rate to 4% or 6% and the numbers will go down:
$ 5 million cash flow, 5 years
(Present value, 10% growth)
- 2% interest: USD 6.30 million
- 4% interest: USD 5.93 million
- 6% interest: $ 5.59 million
This is an even bigger decrease on a dollar and percentage basis than without cash flow growth.
Stocks compete with bonds
Academy Securities’ Peter Tchir told me this is at the heart of the problem: higher interest rates lower the present value of expected cash flow, and that means investors will try to pay less for a stock.
“Companies that are looking to future cash flow growth are at much greater risk as interest rates go up, and this was the part of the market that really drove returns in the equity markets,” he said. “Because of this, some parts of the market, like the Nasdaq 100, which is tech-rich, have been hit much harder than the Dow Jones Industrial Average, where fewer companies expect oversized growth.”
The bottom line, Tchir said, is that bonds compete with stocks as an investment, and bonds are becoming more and more attractive: “If interest rates continue to rise, I can invest more in 10-year government bonds than I did a week ago, and that makes other investments less attractive.”