Why Tech Stocks Could Stumble Amidst Rising Rates
Prospects for higher interest rates sooner rather than later really appear to be disproportionately whacking Tech stocks. Given that many of these companies retain substantial sums of cash net of debt on their balance sheets, this trading behavior may be confusing to many investors. Institutional investors’ concerns likely focus on the discounted value of Tech companies’ future cash flows rather than on its prospective balance sheet condition.
Theoretically, for a company generating $1 billion in free cash flow with a 7% average cost of capital – its discount rate – incurring a two-percent increase in that discount rate, while relatively benign optically, translates to an estimated reduction in value of $17M+ in a year. If our company has 100M shares outstanding and trades at 20x free cash flow, that $17M drop in value results in a share price decline of only $3.43, or about 1.7%. That price change falls well within the range of typical market gyrations and probably, never garners another thought.
However, that theoretical increase in the company’s discount rate also likely results in a down-tick in the cash flow multiple that investors will pay for shares of the company, say from 20x to 18x. Now, that $17M decline in value amounts to a $23.09, or 11.5%, downward revision in value. Even for the most resilient, longest-term investor an 11.5% price drop likely results in at least a raised eyebrow.
Of course investors may argue that rising rates impact companies across sectors and question why Tech trades differently. Two factors, in our view, serve to explain Tech’s potentially increased sensitivity to rates vis-à-vis companies in other sectors: 1) significantly higher expected future free cash flows and 2) elevated trading multiples for those expected future free cash flows.
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