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The specter of rising interest rates in the US (driven by higher inflation expectations) appears to be a factor. Fast-growing companies which are investing agg

by cs702 9y ago

The specter of rising interest rates in the US (driven by higher inflation expectations) appears to be a factor. Fast-growing companies which are investing aggressively today and whose profits lie far in the future, in particular, are exposed to rising interest rates, due to the higher duration of such companies' cash flows. Duration, for those here who don't know, is a measure of the sensitivity of present value to interest rates.[a] Duration rises with the amount of time an investor must wait for cash flows, and vice versa. For example, the present value of $100,000 of cash flow to be generated in 10 years, if the 10-year rate is 2%, is equal to $100,000/(1.02^10) = $82,000; if the 10-year rate rises, say, from 2% to 3%, the present value declines to $100,000/(1.03^10) = $74,000, or a -10% decline. However, if the $100,000 in cash flow is to be generated in 30 years, and the 30-year rate rises from 2% to 3%, the present value declines from $100,000/(1.02^30) = $55,000 to $100/(1.03^30) = $41,000, or a -25% decline. In this example, an increase in duration from 10 to 30 years changes the sensitivity of present value to a 1 percentage-point rise in interest rates from a -10% decline to a -25% decline. The longer an investor has to wait for cash flows, the greater the sensitivity of present value to changes in interest rates. The same ruthless logic applies to companies. The present value of companies whose profitability is in a distant future declines much faster when interest rates rise than the present value of companies certain to generate cash flows in the near future. Until recently, due to historically low interest rates and no prospects for inflation, the stock market has been rewarding high-investment companies that are sacrificing current profits for growth. If interest rates continue to rise (along with inflation expectations), I would expect this pleasant state of affairs to change abruptly -- in which case, strap on your seat belts! [a] https://www.investopedia.com/terms/d/duration.asp https://www.investopedia.com/terms/d/duration.asp

Talyen42 9y ago
If you compare something like Netflix or Tesla, whose valuations are based on the proposition of 10x-ing profits sometime in the future, to something like Apple or GM, whose profits are here and now and may not even increase, would that mean Apple/GM (as an example) might fare better while the market adjusts to rising rates? So far, everything is dropping kind of evenly, it seems, but wouldn't companies with near term cash flows be worth more in a rising rates environment?
- cs702 9y ago
  If I'm right about rising interest rates, the present value of companies with near-term cash flows would decline too, but less than the present value of companies with far-out cash flows.

by cs702 9y ago

Talyen42 9y ago

If you compare something like Netflix or Tesla, whose valuations are based on the proposition of 10x-ing profits sometime in the future, to something like Apple or GM, whose profits are here and now and may not even increase, would that mean Apple/GM (as an example) might fare better while the market adjusts to rising rates? So far, everything is dropping kind of evenly, it seems, but wouldn't companies with near term cash flows be worth more in a rising rates environment?

cs702 9y ago
If I'm right about rising interest rates, the present value of companies with near-term cash flows would decline too, but less than the present value of companies with far-out cash flows.