Growth stocks in an environment of rising interest rates

aroominyork

AlanP_2 said:

maxsteam said:

aroominyork said:

 “Rising interest rates are toxic for (growth, momentum and small cap growth) funds… they have a lot of cash flows projecting into the future because those cash flows are growing very rapidly. If that’s the case then when interest rates rise the value of those future cash flows is discounted very heavily and that means growth stocks are particularly sensitive to rising interest rates... 

Someone is talking bs. It is not growth stocks that should be avoided if you anticipate rising interest rates. You should avoid companies with high debt ratios for what should be obvious reasons.

If you discount 20+ years of potential revenue at 5% instead of 2% you get a much lower "value" today hence rising interest rates do impact on the share price of growth companies.

Could you please explain this using basic ABC terminology?

Prism

aroominyork said:

AlanP_2 said:

maxsteam said:

aroominyork said:

 “Rising interest rates are toxic for (growth, momentum and small cap growth) funds… they have a lot of cash flows projecting into the future because those cash flows are growing very rapidly. If that’s the case then when interest rates rise the value of those future cash flows is discounted very heavily and that means growth stocks are particularly sensitive to rising interest rates... 

Someone is talking bs. It is not growth stocks that should be avoided if you anticipate rising interest rates. You should avoid companies with high debt ratios for what should be obvious reasons.

If you discount 20+ years of potential revenue at 5% instead of 2% you get a much lower "value" today hence rising interest rates do impact on the share price of growth companies.

Could you please explain this using basic ABC terminology?

If you lent me £10 and I promised to pay you back £20 in ten years you would look at the expected interest rate over the next 10 years to see how good a deal that was. If it was 1% then it might seem like a good deal. If it was 5% is might seem like a less good deal. Basically the value of my offer to you is affected by what you could get elsewhere.

AlanP_2

An overview of DCF here - https://www.investopedia.com/terms/d/dcf.asp

Basically a £1 someone will give you in 5 years time is only worth x% of a £ today so DCF enables you to work out what x is over a given time period.

Buying a share in a company is buying a portion of their future revenues.

Very Basic Example:

Take M/Soft @ £100 a year revenue. If interest rates are 2% then next years £100 is only worth £98 in today's terms, whilst at 5% it is only worth £95. If the discount rate used (often the interest rate that an alternative offers) goes up the then the value of tomorrow's earnings to you as an investor are lower and so the share price will adjust to reflect this.

Would you invest in M/Soft for 12 months at say £96 if you were going to get £98 in return after 12 months compared to £97.92 in a savings account at 2% - YES.

Would you invest in M/Soft for 12 months at say £96 if you were going to get £95 in return after 12 months compared to £100.80 in a savings account at 5% - NO.

Hence price for M/Soft shares will fall as it not as valuable anymore compared to alternatives. 

Extend that calculation out for 5-10-20 years and hopefully you can see why interest rates affects the value of growth shares.

To be fair all share values are affected but the impact is greater on those that were valued yesterday against their growing revenue streams in to the future, particularly those that aren't in regular, steady profit yet e.g. Tesla as opposed to a  value share like Unilever that will just carry on plodding along spinning off regular Dividends out of profits with a bit of capital growth as well (I hope as I have some).

DCF is also part of the way that organisations look at investment options as well e.g. Cost v Return for oil drilling sites over what might be 40/50 years or a new factory. If the DCF analysis of building a new factory in a Country A is better than in Country B  then logic suggests they will go for Country A (until the Gov't in Country B, or even Country C, throws them an incentive to alter the sums).   

As individuals we all do this without realising to a certain extent - New Car / Used Car for example, or Savings Account A or Premium Bonds. All just examples of finding the "best value" we can get for our money.
 

Thrugelmir

As the share price fails to grow, Then companies find the cost of capital more expensive to raise, i.e. share issuance. US growth companies are constantly tapping the market for new funds. 

Tesla issued almost new 35 million shares in the first nine months of 2020. Add in conversion rights and employee stock stock option schemes and the total is around 52 million. A 6% dilution for ordinary stock holders. Growth comes at a cost. In the form of dilution of EPS. 

Liamoac

These past 3 days have been a killer. Watching months of profits just dwindle away

Liamoac

That said the 10 year yields are falling. 

Hopefully this is a result of the volume this week and people start trading again next week. 

In it for the long haul anyway.

Thrugelmir

Liamoac said:

That said the 10 year yields are falling. 

The Fed has a major issuance programme ahead to fund all of Biden's spending programme. Market digestion is likely to become an issue. The new economic cycle has only just begun. 2% yields won't come as a surprise at some point in time. 

aroominyork

What is market digestion...?

Thrugelmir

If large tranches of stock are auctioned frequently. Then investors may demand a higher starting yield to take up the issue on offer. 

aroominyork

Thanks for the discount rate explanations. However, if interest rates are raised to control inflation, and assuming a company's prices/revenues rise in line with inflation, isn't there a zero sum game of whether to invest in the company which might generate the same revenues in real terms, or invest in bonds which might also just track inflation?