Why this rate-driven selloff is hitting tech stocks hardest

What is behind the decline in tech stocks? A model Wall Street uses to value stocks is flashing cautiously.

Tech stocks are in a correction. The Nasdaq 100, the top 100 non-financial stocks in the Nasdaq, is down 10% from the all-time high it hit just three weeks ago, but many big names are down nearly 20%.

Tech in correction
(% of 52 weeks high)

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

What is happening? The market is concerned 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 high-flying technology stocks?

It has to do with the way Wall Street values ​​stocks. The market is a discounting mechanism: It’s a way of finding out what a future cash flow – or income – is worth today.

Known as the Discounted Cash Flow Model, this model is at the heart of the problem for technology stocks.

Shares compete with other investments such as 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 own money, the sooner you can invest it. If I have $ 100 now, and I can invest it and get 2% in a bond today, that means I’ll have $ 102 next year. A hundred dollars a year does not help me because I cannot invest it.

What does this tell us? It tells us that a dollar today 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 worth in a stock that you want to hold, say, for five years? Most stocks are valued based on how much money they can generate in the future. Discounted cash flow uses a formula to calculate the present value of an expected flow of future cash flows.

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

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

Second, you need to estimate the discount rate. Simply put, what is the opportunity cost of owning alternative investments? That would be the minimum required return you would accept. Usually this is the prevailing interest rate.

Finally, you discount those expected cash flows back to the present time.

Here’s a greatly simplified example. For example, say you have an XYZ business that generates $ 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

• 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 in five years. Is It Really Worth $ 5 Million Today?

It isn’t, because inflation affects the value of money: $ 1 million in five years isn’t worth as much as it is now, or even in a year.

So we have to discount what that future $ 1 million will be in current dollars. To do that, we need to estimate interest rates.

Let’s say interest rates are 2%.

Using a complex formula, that $ 5 million discounted cash flow would be significantly less, say $ 4.71 million. In other words, assuming interest rates of 2%, the value of that $ 5 million cash flow – the present value – is $ 4.71 million.

Here’s the problem with rising interest rates and stocks: As interest rates rise, the present value of that $ 5 million falls.

Let’s say rates go from 2% to 4% or even 6%. The discounted cash flow – its present value – of that $ 5 million would fall:

$ 5 million cash flow, 5 years
(current value)

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

The higher the interest, the lower the present value of that future income stream.

It gets worse when you’re dealing with high growth stocks, like many technology stocks.

That’s because many technology stocks have assumptions for rapid growth built into them. For example, instead of cash flows that would always be $ 1 million per year, many would expect to grow 10%, 20%, 30%, or more.

In that case, an interest rate hike would eat up the present value of the investment even more.

Let’s say the company grows cash flow by 10% per year for five years. Assuming an interest rate of 2%, the present value would be about $ 6.30 million after five years, but change the interest rate to 4% or 6% and the numbers drop:

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

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

This is an even greater drop, on a dollar and percentage basis, than if there were no cash flow growth.

Peter Tchir of Academy Securities told me this was the crux of the problem: Higher interest rates lower the present value of the expected cash flow, and that means investors are willing to pay less for a stock.

“Companies that rely on future cash-flow growth are at a much greater risk as interest rates rise, and that’s the part of the market that has really driven returns in the stock market,” he said. “That is why some areas of the market, such as the Nasdaq 100, which contains many technology stocks, are much more affected than the Dow Jones Industrial Average, where fewer companies expect excessive 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 continue to rise, I can invest more in 10-year Treasury bonds than I did a week ago, and see other investments as a result. look less attractive. “