Why are my growth stocks falling? 

 Growth stocks, particularly tech stocks, have ruled the roost for many years, endearing themselves to investors of all types. Why? Well, you know, because they have performed so well over the years, especially those years in the wake of The Great Recession and then once again in the aftermath of the COVID lockdowns and snap recession. But last year something changed. That almost sure shot bet of buying the dip vanished into thin air, and that shift in behavior seemed to occur right around the time that inflation picked up and the Fed began threatening rate hikes. Bond yields were rising, and you probably read that when bond yields go up growth stocks go down…well, you probably didn’t have to read about it. So, why ARE growth stocks under such duress? The simple answer is that it comes down to the way that stocks are valued. 

So, what is the value of a stock? That question that has dogged investors since the beginning of time. Clearly, there is no single answer and there are many differing opinions, which is why we have markets. Many investors buy stocks because they have a gut feeling about a company’s prospects or because they like the products produced by the company. Some investors are always in search of stock recommendations from their friends, hair stylists, and the poor stock analyst who gets cornered into a discussion on line at Starbucks or in an elevator. For analysts who are charged with making recommendations and picking price targets, coming up with a stock’s true value is a more serious quantitative endeavor that typically involves complex financial models. Because every model is different and they vary from industry to industry, I will cover the high-level basics of what goes into the determination of what a stock is worth. Now, I know that this is going to get a bit technical, but it is important to at least get the basics so you can understand the critical drivers. 

 The Dividend Discount Model (DDM) 

 The dividend discount model is a method for predicting the value of a stock built on present value of all its future dividend payments. If the sum of all future dividends paid by the company discounted to today’s dollars is less than the current price of a stock, then the stock is considered to be overvalued. Vice versa, if the discounted dividend value is higher than the current stock price. Why dividends? When an investor buys a stock, they are, in effect, lending money to a company and, as such, expect to get a return on their investment. If a company is successful and profitable, it will pay investors with dividends. The DDM theory, therefore, is centered around the value of a stock being based on the present value of future returns. If you have a background in finance this might remind you of Net Present Value (NPV), which is a method for calculating current value of future returns. The DDM is actually based on the same concept, which is the time value of money. 

The time value of money 

Consider an example in which you would be given a chance to either receive $1,000 today or $1,000 in a year from now. Rationally, you would take the money now and put it in the bank to collect interest. If you left the money in the bank for a year with an interest rate of 3%, the account would be worth $1,030, which would be far better than taking the $1,000 in a year from now. The value in one year is called its Future Value, which is calculated as follows: 

𝐹𝑉=𝑃𝑉 × (1+𝑟) 

Where: 

FV is the future value 

PV is the present value 

r is the rate of return 

In our example: 

FV = $1,000 × (1+.03) = $1,030 

Therefore, using the same variables, we can re-arrange this equation to determine the present value of a future return as follows: 

𝑃𝑉= 𝐹𝑉 / 1+𝑟 

Using this equation on our same example in which you were offered $1,000 in a year from now, you can determine what that money would be worth today as follows: 

PV = $1,000 / 1+.03 = $970 

Looking at this from an investment perspective, an investment that will pay you $1,000 in a year with interest rates at 3% is worth $970 today. If someone offers you this opportunity for anything less than $970, it would be considered cheap and you should, in theory, take the opportunity. 

If we apply this same analysis to a stock, the equation becomes a bit more complicated, but it is based on the same core concept of present value. If we invested in a stock and hold it forever, 

we would have to consider all future returns of the stock in order to determine its present value. The way we do that is by expanding our earlier equation as follows: 

𝑃𝑉= 𝐶𝐹1 / 1+𝑟 + 𝐶𝐹2 / (1+𝑟)² + 𝐶𝐹3 / (1+𝑟)³ +⋯+ 𝐶𝐹𝑛(1+𝑟)ⁿ 

Where: 

PV is the present value of an investment 

CF1 – CFn are future cash flows received from an investment, in our example the dividend 

n is the final year of the investment 

r is the rate of return expected by an investor 

At this point, you might recognize that guessing at and adding up all the future returns of stock is unlikely to be accurate, especially the farther out in the more distant years. As you might expect, finance has an answer for that. The way an analyst can deal with that is by forecasting cash flows, or dividends, for as long as they can possibly be accurate and then coming up with something known as a Terminal Value. Let’s say that you can accurately guess at the returns of a company over the next three years (most analysts look out 3 to 5 years). We can use the following equation to come up with a value: 

𝑃𝑉= 𝐶𝐹1 / 1+𝑟 + 𝐶𝐹2 / (1+𝑟)² + 𝐶𝐹3 / (𝑟−𝑔) 

Where: 

PV is the present value of an investment 
CF1 – CF3 are future cash flows forecasted over the next three years 
r is the rate of return expected by an investor
g is the dividend growth rate expected to happen in perpetuity. That means whatever we expect to get in years three will grow at a rate of g forever after. 

The third expression of the equation is its Terminal Value. 

About those dividends 

Now that we know how to put a current value on future dividends, we need to consider a number of factors. First, how confident are we that we can continue to get those dividends? Further, how realistic is it to assume that we will get those dividends forever? These are two of the primary drawbacks to using the dividend discount model. If a company is paying dividends, they have good growth prospects, and we expect the economy to remain stable over the next few years, we can probably come up with a good estimate of value by using a conservative growth rate for 

the terminal value. Conservative means that we could use a growth number that is lower than the current growth of the company in order to factor in soft patches in the future. What about companies that don’t even pay dividends, such as Amazon.com or Tesla? How can we value those? It gets a lot more complicated, and in practice, many analysts use alternative valuation methods for these stocks, which are largely based on multiple analysis that relies on the markets to put values on companies. 

“But what about the finance,” you ask? Well finance has an answer for that too, but you might not like it. For growth companies, which do not typically pay out cash flow in dividends, but rather, plough back profits into the company investing in future products or technologies, investors make investments for future potential. Perhaps the company will discover the next big thing and make lots of money in the future. Apple started out as a growth company ploughing back profits for many years before it began paying dividends to shareholders. In the case of a growth company, we would use equations related to the ones above. In these, we would calculate the Present Value of Future Growth (PVGO). The calculation, which attempts to bring future returns into today’s dollars is tricky and involves many assumptions of future earnings being invested into projects that would yield the company positive returns. Sounds complicated, and it is. What actually ends up happening is that we observe the market value of a company, which is the de facto present value and fill in the other side of the equation with as much factual data as possible. If we know what a company is worth without factoring in growth based on assumptions about earnings, assets, and market cap, we can calculate a growth company’s PVGO. 

Mathematical challenges 

So here we are, in just a few pages, I covered, through gross oversimplification, what MBA students spend several years learning about. Now, I will simplify it even more and answer the question we asked ourselves at the very head of this newsletter. Why are my growth stocks falling? If I can force you to look back to all the equations I wrote out above, you would note that all of them have r (expected rate of return) in their denominators. That rate of return is based on bond yields. You would expect to at least get the yield of a US Treasury note, wouldn’t you. In fact, you would hope to get more, because in stocks, you are likely taking more risk than you would be with the US Government. But let’s just assume that you have low expectations, and you would be happy to receive as much as a no-risk treasury. In that case you would simply use current treasury yields of maturities that match your investment time horizon. Because that r, expected rate of return, or in this case, Treasury yield to maturity is in the denominator, if it goes higher, the value of the equation goes lower. Pure math. If interest rates go higher, because of how a stock’s value is calculated, the theoretical value of the stock gets lower. So, if all things are held constant (including the stocks market price), a stock can become overvalued if Treasury yields are going higher… which they are, if you hadn’t noticed. 

Before you feel as if you were hoodwinked by some finance PhD with a pocket protector, there is something else, and it is good news…as long as earnings keep growing. In those very same equations, the numerator (top number) contains future earnings or dividends. The larger those are, the higher the value of the stock. In the case of future growth, that g (or perpetual growth 

rate) is in the denominator of the terminal value, but because it is subtracted from the r (expected rate), the bigger it gets, the more valuable a company’s stock becomes. Though that is also some silly math at least it makes sense. Companies that have big revenues and large long-term growth prospects are worth more. So here is the cheat sheet: 

• • Rising bond yields and interest rates are negative for stock values, and vice versa. Simple math. 
• • Companies with big and growing future earnings and dividends are worth more than those with smaller and diminishing future earnings. Also, math, but more intuitive. 
• • Companies that have bigger potential growth in the yonder years are worth more than those with smaller growth. Also, math, but also intuitive. 

Currently, interest rates are rising. Short term yields are going up because the Fed is raising its key lending rate. Longer maturity yields are higher because investors need higher yields to compensate for inflation. Remember yields higher, value lower? Additionally, the economy has entered a slower growth regime as higher costs have slowed consumption. Higher prices have also caused many consumers to put off purchases until the economy regains its footing. For some companies, that means lower future earnings, and lower growth. Remember, lower earnings and lower growth, value lower? So, it is by simple math, some of it intuitive, that your growth stocks are struggling. 

In conclusion 

Discounting the future returns of an investment into today’s dollars is a good way to determine the value of an investment. In the case of dividend paying stocks, we can use dividends along with growth assumptions to come up with a good estimate of a stock’s true value. Challenges to the Dividend Discount Model come when applying the financial math to companies that don’t pay dividends, such as the majority of our favorite growth/tech stocks. In these cases, alternative valuation methods are used relying on market value to assess how much of a stock’s current price is based on what is known and what investors hope will be. In a world where many up-and-coming companies tap into public equity markets, valuation becomes a tricky and risky venture. That risk only increases as economic prospects, inflation expectations, and interest rates get blurry in the near-term. Investors must put a lot of hope in management’s finding a way to not continue to achieve earnings growth…just long enough for interest rates to come back down. Investors need to tread carefully in those investments as “hope” is not a strategy.