Discounted Cash Flow
Corporate earnings and economic growth matter to investors, but the direction of interest rates is the most dominant issue in equity markets. This can be explained partly by Discounted Cash Flow (DCF): a method used by investors to estimate the value of a company based on its expected future profits.
Higher interest rates reduce the value investors place on companies’ potential future earnings. And tech companies have attracted high stock market valuations based on expectations of future rapid growth, even if they are lossmaking today.
“That’s why we see that growth companies are hit the hardest in the sell-off,” says Schmedders, “through the higher interest rates and heavier discounting of future cash flows.”
It also explains the rising price of unloved value stocks, such as energy majors BP and Royal Dutch Shell, along with financial groups HSBC and Allianz, which have all posted considerable gains in 2022. “Oil and finance make money already, they are not sitting on castles in the sky,” Schmedders says. “So they are hit less hard than Zoom or Tesla.”
This reflects an economic concept known as: the Time Value of Money (TVM), the idea that a sum of money is worth more now than at a future date, in part because of inflation, which erodes the purchasing power of a currency over time.
Annual US consumer price inflation is at its highest in nearly 40 years, reaching 7% last month because of pandemic supply chain disruption, and labor shortages and record job openings, which have pushed up wage growth. “The Fed simply had to act,” says Schmedders.