- Growth stocks are priced in with explosive growth expectation
- Due to discounting effect, future earnings are prone to changes in interest rate. When interest rate raise, these future cashflows would be heavily discounted
Growth stocks are highly dependent on their future earnings/cashflows.
It is not rare to see that when companies release their earning report, that despite the earnings being good, the price of the stock fall. This is due to the market having expected the company to have done better.
Future earnings are priced in. The current stock price takes into account how much the company would earn in the future.
A simple analogy would be company A and B both having the same profits today. But company A is going to start a campaign of sorts and is expected to have twice of company B’s earning the following year.
It would make sense that the stock price of company A is higher than B as it has a higher potential return.
The return is not guaranteed, but is still taken into account.
Growth stock takes this idea of pricing in future cashflow to the extreme. Don’t talk about profits, often times, they make a loss running the company in attempt to scale up the company or on R&D.
The graph above is Tesla’s net profit margin.
Tesla is a great example of a growth stock (some call it hyper-growth) that do not even make a net profit for years.
Frankly, I do not have much knowledge about Tesla, but one thing is certain. Its current earning does not justify its price. The current PE ratio as of March 2021 is above 1000! To put things into perspective, S&P500’s PE ratio is 39 (still very high compared to historical value).
Most of its price are derived from future earnings. That is why it is important to consider the impact of interest rate which has a direct impact on the current value from the discounting of future cashflow.
What happens if Interest Rate goes Up?
Interest rate has been a downward trend for the past 40 years from the 1980s when Paul Volcker raised interest rate. (I recommend reading up on this event as it helps investors understand why equity and bond performed so well in recent decades)
By following the trend, it is likely that interest rate would continue to fall. However, the past is not indicative of the future. And also, the past year (2020) had been a year unlike others.
We had COVID-19 outbreak, Quantitative Easing (QE), policies to delay loans (mostly mortgage loans), unemployment issue and stimulus check.
With various forces at work, inflation and deflation both seemed to be a possibility. Experts themselves are constantly in a debate about whether it is inflationary or deflationary. Both camps strongly believing in their viewpoint.
However, I do not want to go down this rabbit hole in this post as it goes deep.
I just want investors to understand the effects of raising interest rate on growth stock before buying into growth stock. So that investors could take into account interest rate risk.
When interest rate goes up, the future earnings are discounted more heavily and their falling current value could drag the stock price down. More on this discounting mechanism could be found here.
Here is a link to a simple field that you can change the future earnings and interest rate to see how the interact. Try playing around with the values and you would see that interest rate affects the earnings furthest out in the future.
Set the rest of the value to 0 leaving the earnings of the first year to 1 and see its current value. Then do the same but this time set the earnings of the tenth year to 1. It could be seen that the earnings further out in the future is more heavily discounted.
By adjusting the interest rate, you could observe its impact on current value.
The reason why interest rate have such a big impact on the valuation of growth stock is that the explosive earnings expected is far out in the future, which is also heavily discounted to the current value.
Narrative of the Bond Market
In recent years, there have been less of an incentive for investors to buy bonds due to the low yield.
Firstly, there is little upside to holding bonds. When rates are so low, it provides an abysmal return. A 5-year bond only had a yield of 0.86%. Even if rates go to zero, there is little capital gain to be made.
Furthermore, if rates were to go up, bonds would suffer capital loss.
Secondly, when rates are at such low rates, it provide little protection against market crash. There is a common conception that bonds are used to hedge against equity losses as they are anti-correlated. But, when rates are so low, it could only provide little downside protection as a hedge.
But, if rates were to go up, bonds would become more appealing to investors.
Investors might re-allocate some of their equity positions to bonds. Since growth stock is also part of the equity, it might be affected too.
When rates rise, the main bulk of how growth stocks are priced with regards to would be heavily discounted. Growth stocks might crash due to the sell off as investors re-evaluate the stocks.
Bonds would also become more competitive as an investment and might compete for funds against equities as they become more appealing.