Dot-coms are not immune to effects of interest rates

By DAVID MOON, Moon Capital Management
January 14, 2001

Last year, when the Federal Reserve Board orchestrated a series of interest rate cuts, supporters, promoters and owners of a number of high tech (but non-profitable) companies argued that interest rates were irrelevant to the values of those fledgling businesses. After all, no respecting dot.com would ever borrow money when the equity market is so quick to throw money at any group of teenagers in a garage with a business idea ' regardless of little details like earnings or even cash revenues. Increased rates historically resulted in lower stock prices, for a variety of reasons. But with the new Holy Grail, things were different. Interest rates were irrelevant.

The Wall Street old fogey types found that logic, well ' illogical. Higher interest rates increase the cost of capital, which decreases the value of almost all financial assets. 'But these businesses are different,' argued the high-tech apologists.

While rates were increasing, rates were supposedly irrelevant. But when the Fed decreased rates 10 days ago, how did dot.com investors immediately react? With a 14 percent increase in prices, the largest one-day percentage increase ever in the NASDAQ. It made absolutely no sense. In light of the desperate argument of some investors last year, it became more evident that the dot.com Emperor had no clothes. When the Fed recently cut rates, no one argued that interest rates were irrelevant to the value of profitless, high-tech companies.

Do changes in the Fed discount rate effect the values of businesses or not? Yes. There are two primary influences interest rates have on stock values: valuation and economic. The value of any stock (business) is simply the present value of all future cash flows the business generates. Present value is a simple algebraic calculation with an interest rate factor in the denominator. (For those of you in Alabama, the denominator is the bottom part of the equation.) As the interest rate factor increases, the present value calculation decreases. Likewise, as the interest rate factor decreases, the value of the cash flows of a business increases. Of course, the equation requires that the business generate actual cash flow, otherwise the numerator (the top number) is zero, resulting in an incalculable number.

The economic impacts of interest rate changes are multiple. Lower rates motivate some companies to expend more money on capital and operating items. This increases the operating revenues of their suppliers. As those operating revenues increase, the cash flows of the businesses increase, increasing the nominator of the present value calculation.

Based on these two influences ' valuation and economic ' interest rates do affect the value of companies and, ultimately, their stock prices. But should a single, one-half percent rate cut in rates increase the value of NASDAQ stocks by 14 percent - particularly since so many of those companies have no cash flow? Of course not. Since the original euphoric reaction, stock prices have declined somewhat, but the risk remains: will desperate investors cling to any possible hope for higher stock prices, even in the face of logic? This wishfullness is how the NASDAQ originally came to be so overvalued. Rather than hoping for help from Greenspan or a bucket of money to fall from the heavens, investors should be looking for more simple indicators of investment attractiveness: things like earnings and cash flow.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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