Why are tech companies more sensitive to interest rates?

It all comes down to the magic of discounting cash flows

While techno-optimists trumpet the ideology of supporting high growth technology companies at all costs, the reality is that macroeconomic cycles really do matter to investing.

Given that new technologies are also often capital intensive and unprofitable in the near term, investor sentiment and appetite becomes important to business building. Even if you’re not interested in being an investor, the reality of the world is that if you work in tech, you should at least pay some attention to macro cycles.

Many VC’s try to skirt the macro climate by declaring that venture is a practice of “secular, not cyclical growth”, “asset selection vs. price optimization”, or, most vague of all: “a power law game”. I’ve always found these platitudes to be unsatisfactory. As history has show many times over, the math will always matters in investing.

Sometimes, the macro climate matters even more to technology companies than to those in other sectors. A few weeks ago I mentioned that technology companies are more sensitive to interest rates than companies in other sectors. A few readers asked for more detail, so this week I figured we could walk through an example:

Example 1: Tech Company valued at 7.5% discount rate

In this simple example, we can see a DCF valuation for a fairly large, but high growth tech company. In the long run all companies all valued on free cash flow, but this company won’t be profitable for a while, so we’ve projected performance out for 10 years.

In this example, the company actually generates a negative NPV of cumulative free cash flow over the next ten years, so all company value comes from the terminal value (which estimates the present value of every year of FCF after ten years). In this example I arbitrarily picked a discount rate of 7.5% (slightly below the long term average return of the S&P).

Sometimes, however, macroeconomic factors change. In the real world, the risk free rate has jumped by 500 bps / 5% in the last two years. If we apply the same increase in discount rate in our example (without changing any of the underlying business performance), the NPV craters:

Example #2: Same Company valued at 12.5% discount rate

All else equal, increasing the discount rate by 5% reduced the NPV of this business by nearly 75%. Said differently, if you bought a share in this Company thinking it was fairly priced at the old rate, you would’ve lost three quarters of your money as rates increased.

For reference, when I ran this same math on a lower growth (but currently profitable) services business of the same size, the NPV decreased by ~30%).

Summary

When assigning a value to anything, we always try to value it using today’s dollars. As there is an opportunity cost associated with investing in something today, we attempt to discount future earnings to assess their present value.

Technology companies are often fast growing, but unprofitable in the near term. As future profits are worth less to us than present day profits, this means that unprofitable companies have to grow much faster in the near term, before eventually becoming hugely profitable in the outer years. Said differently, most of a tech company’s “value” is captured in the far future, so discount rates have an outsized impact.

The secret here is assessing how much to discount future profits by (i.e., the discount rate). In a macro cycle in which capital is expensive, these future profits will be more heavily discounted. In a macro cycle in which capital is cheap, tech companies balloon in value and begin to trade a massive multiples (e.g., software companies in 2021).

Savvy investors will take a long term view on interest rates and business cycles, ultimately pricing those into valuations today. In a frothy market, however, most investors always seem to convince themselves that the good times will never end.