Tech companies valuation

Usually tech companies/stocks are valued using one of the two methods:

DCF (discounted cash flows) method that is sensitive to interest rates raise (if rates up value down)

EBITDA or revenues multiples are sensitive to interest rates as cost of debt raises and profitability worsens if internet rates increase.

why on the news it's usually mentioned that tech valuations are more negatively affected by an interest rates increase versus other sectors?

If we talk about tech stocks in general, a majority of their value is tied up in more distant cash flows / terminal value in a standard DCF analysis. So if interest rates go up, the more distant cash flows are impacted more due to the e^(-rt) discounting factor.

The reason tech stocks are seen as 'expensive' is because the P/E ratio for example is measured against next years earnings. WHen we measure it on projected earnings 4 or 5 years later, the P/E comes down to normal levels. this is one indication that tech stocks are valued for more distant earnings/cash flows, and also the reason for their higher interest rate sensitivity.

Edit: Lets say we start with 100 units of current earnings for 2 companies A and B. Company A annual growth rate = 20% and Company B annual growth rate = 3% For simplification purposes, let us consider the same discount rate for both companies of 5%.

Let us simply consider the next 2 years. Company A posts 120 and 144 units and company B posts 103 and 106.09 units of earnings for Year 1 and Year 2 respectively. Let us consider 2 scenarios for both companies.

Scenario 1: Interest rates stay at current levels. Company A's DCF equation (without terminal value) is 100 + 120/1.05 + 144/(1.05^2) = 344.898 Company B's DCF equation (without terminal value) is 100 + 103/1.05 + 106.09/(1.05^2) = 294.33

Scenario 2: Interest rates go up, and discount rate increases to 6% Company A's DCF equation (without terminal value) is 100 + 120/1.06 + 144/(1.06^2) = 341.36 Company B's DCF equation (without terminal value) is 100 + 103/1.06 + 106.09/(1.06^2) = 291.58

If we see the % fall in discounted cash flows, company A has 1.02% drop while company B has a 0.93% drop in earnings. The difference just two years out may not seem much, but as you add more years, this difference increases.

• Two related but distinct concepts here. There is the near/medium-term growth from the current earnings (used to calculate P/E) to their "terminal" value (or whatever proxy you want to use for long-term "normal"); and then the discount rate that you apply to the latter. These growth and rates elements are distinct. And the long-term rates used to discount the latter should be detached from short-term policy rates! – demully Mar 6 at 11:18
• @Knio, thanks for the explain. As cash flows are more distant for tech than for other sectors, tech stocks are more sensitive to interest rates. Can you clarify why investors usually assume more distant cash flows for tech stocks (even for mega cap like Google/FB)? – Student Mar 6 at 14:21
• I have edited my answer with a numerical example to illustrate it better. The point stands for megacap tech as much as it does for high growth companies in other sectors. It actually even stands for deep Value, cyclical stocks which have most of their value in back ended cash flows. However in those cases, the increase in cost of debt can be pretty devastating and often override the cash flow discounting issue.. In the above example, i have used earnings and cash flows interchangeably for simplicity. – Knio Mar 6 at 23:51
• ok makes sense. thanks! – Student Mar 8 at 18:14

Over the last decade or so, many enterprise technology companies migrated from the license revenue model to the subscription model, also known as SaaS.

Low inflation allows companies to amortize the substantial upfront cost of developing the software products over a long period of time while charging reasonable subscription fees.

With high interest rates, the present value of future subscription revenues is dropping faster than the industry's ability to raise prices in a competitive environment. The SaaS model hasn't been tested in a period of high inflation, and the market doesn't like the uncertainty.

"why on the news it's usually mentioned that tech valuations are more negatively affected by an interest rates increase versus other sectors?"

It's specifically long term interest rates that affect tech/growth companies, since their earnings are supposed to be heavy weighted towards longer maturities.

If short term interest rates spike, other companies, like energy or real estate, will be more affected.