Why this fee-driven settlement is affecting technology stocks more

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

Technology stocks are in a correction. The Nasdaq 100, Nasdaq’s 100 largest non-financial stocks, is 10% below the historic record set just three weeks ago, but many big names have fallen by almost 20%.

Correction technology
(% of maximum 52 weeks)

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

What is happening? The market is concerned about rising interest rates and the Federal Reserve may not be able to control it.

Why would an increase in interest rates hurt stocks, especially high-tech 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 technology inventory problem.

The 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 look at the value of money over time. The sooner you have money, the sooner you can invest it. If I have $ 100 now and can invest and receive 2% today on 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.

What does that 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 security.

How much is a dollar invested today in a stock you want to hold for, say, 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 calculate the present value of an expected future cash flow.

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

The problem is that nobody knows exactly how much cash a company will generate in a year. It depends on many factors, including the economy, management, competition and the nature of the business. The farther you go, the harder it gets. It is much more difficult to estimate cash flow in five years than in one year.

Second, you must guess the discount rate. Simply put, what is the opportunity cost of owning alternative investments? That would be the minimum required rate of return that you would accept. Usually, it is the interest rate in effect.

Finally, you discount these expected cash flows back to the present day.

Here is a very simplified example. Suppose you have the company XYZ that is generating $ 1 million in cash this year and expects to generate the same $ 1 million in cash flow growth 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: it’s $ 5 million in five years. Is it really worth $ 5 million today?

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

Therefore, we need to discount what that future $ 1 million will be in current dollars. To do this, we need to guess the interest rates.

Let’s say interest rates are 2%.

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

Here is the problem with rising rates and stocks: as interest rates go up, the present value of that $ 5 million falls.

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

$ 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 the rates, the lower the present value of that future earnings stream.

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

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

In that case, an increase in rates would further consume the present value of the investment.

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

$ 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 greater decline, in dollars and percentages, than when there was no growth in cash flow.

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

“Companies that depend on future cash flow growth experience much greater risk with rising rates, and that has been the part of the market that has actually generated returns in the stock market,” he said. “This is why some parts of the market, like the Nasdaq 100, which is heavy on technology stocks, are being hit far more than the Dow Jones Industrial Average, which has fewer companies expecting overgrowth.”

The bottom line, says Tchir, 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 earn more by investing in 10-year Treasury bonds. years ago than a week ago, and that makes other investments seem less attractive. “