Our advisors utilize their experience and expertise and that of their colleagues to develop the best solutions for your complex personal and professional financial situations.
Actionable planning strategies to inform and guide your decision-making.
August 17, 2021
This year we’ve seen a lot of attention paid to higher inflation and, along with it, higher interest rates. The stock market has generally responded negatively to the risk of both, but nowhere has the response been stronger than aspiration-ally-valued technology stocks.
Interest rates have a significant effect on stock prices due to the Discounted Cash Flow (DCF) valuation method. Fundamentally, DCF attempts to normalize future earnings by discounting them at a rate that compensates for both inflation and the idiosyncratic risk of those earnings not being realized. As the discount rate rises, it not only has the effect of decreasing each individual period’s earnings, but the effect is exponential the further we discount into the future.
The reason why technology stocks have been hard hit by this year’s rise in interest rates is because many technology stocks have earnings that are low in the near-term years but are projected to grow rapidly in the out-years. Compare recent IPO (Initial Public Offering) stock ROKU to mature AT&T, for instance. Both are in the telecommunications sector and both participate in the creation and distribution of media content. Here are the profiles for their earnings over the next few years:
Roku’s earnings are projected to occur mostly in year four and beyond. The $11.02 of estimated 2025 earnings gets dis-counted back by the 4th power of (1 + the discount rate). The slightest rise in the discount rate will have an outsized effect on these 2025 earnings, which represent the bulk of Roku’s value.
By comparison, AT&T’s earnings estimates are far more stable and therefore derive more value from their current and nearby years’ earnings. Thus, AT&T is not as affected as Roku when interest rates rise. As the 10-year treasury rate rose from 1.01% on January 27th to 1.73% on March 18th of this year, here is how these two stocks responded. AT&T barely budged while Roku dropped significantly.
And Roku isn’t an isolated case. Various tech, IPO, and SPAC companies faced similar headwinds—and similar performance characteristics—during the 1st quarter’s bout with rising interest rates.
It should be recognized that interest rate moves and their effects on stock prices are transient. Enduring share price movements come from the size, stability, and reliability of company earnings. While this article has focused on technology stocks and the outsized effects of interest rate movements on their share price, these are often the same companies that are building lasting earnings power through disruptive, novel technologies.
Understanding the effects of interest rates on share prices via the DCF model can give comfort during periods of market volatility. The ultimate decision to buy, sell, or hold individual stocks is more appropriately gauged considering a company’s long-term earnings power.
Please read important disclosures here.
Ben is the Chief Investment Officer and a Partner in the New York office. He leads the firm’s Investment Committee and is a member of...
Ben Pace, Tom Cohn and James Lebenthal
December 6, 2022 — Despite the persistency of inflation and the magnitude of rate increases in 2022, the economy has generally remained resilient, buoyed by the inherent strength of the U.S. consumer and a strong labor market.
December 5, 2022 — Though difficult to engineer, an economic “soft landing,” in which inflation is mitigated without a recession, seems increasingly possible.
December 2, 2022 — Partner Paul Chmielewski discusses common discretionary distribution standards to help mitigate trustee confusion on the topic.
December 2, 2022 — Partner Paul Chmielewski highlights the gift, estate and GST tax changes for 2023.
November 22, 2022 — Principal Cheryl Donaldson shares an overview on the potential long-term value of maximizing 401(k) savings and the optimal 2023 401(k) contribution election amounts.
Curious about learning more? Let’s talk.
Tell us about yourself and your current financial situation without cost or obligation. Receive an introduction to a wealth management colleague, have a personal conversation, and get your questions answered.