On Tuesday, the market value of Snap, the company behind the social media app Snapchat, plunged 43 percent after the company warned that its revenue and profits for the second quarter would fall short of previous guidance. Snap has seen its stock price decline an incredible 85 percent since its peak last September.
A number of other up-and-coming technology companies have suffered dramatic share price declines recently:
- Airbnb fell 6 percent on Tuesday and is down 48 percent from its peak in November.
- Tesla fell 7 percent on Tuesday and is down 48 percent from its peak in November.
- Block (formerly Square) fell 9 percent on Tuesday and is down 71 percent since October.
- Uber fell 9 percent on Tuesday and is down 55 percent since October.
- Lyft fell 17 percent on Tuesday and is down 70 percent since November.
A lot of articles have been written about the falling stock market, and many blame fears of an impending recession. Those fears are well founded. As wrote back in March, recessions frequently occur in the wake of rising oil prices, especially if the Federal Reserve overreacts to them and hikes interest rates too much.
But discussions of the falling stock market frequently fail to mention that interest rate hikes put downward pressure on stock prices directly, whether or not they cause a recession. Higher interest rates mean people place a higher value on current spending power relative to future spending power. A share of stock is a claim on a company’s future profits. So the higher interest rates are, the less valuable those future profits will be in present-dollar terms.
Unpacking this basic principle of finance can help us understand a lot about the current economic environment. It explains why fast-growing technology companies are getting hammered much harder than stodgy companies like electric utilities or insurance companies. And it also explains why startups may be facing a grim fundraising environment over the next year or two—even if we avoid falling into a recession.
High interest rates mean low asset prices
So far, the Federal Reserve has only raised short-term interest rates modestly—by 0.75 percentage points—since slashing rates to zero two years ago. But the Fed has signaled that more hikes are imminent, and the market has already “priced in” some future hikes. You can see this, for example, in the market for 10–year treasury bonds. These bonds currently yield 2.86 percent, up from 1.28 percent last August.
Interest rates are society’s way of comparing dollars today with dollars in the future. If your bank pays 2 percent interest, you can put $98 in the bank for a year and wind up with (almost) $100. And you can also look at things the other way around: suppose someone offers you an IOU that pays $100 a year from now. How much should you be willing to pay? If your bank is paying 2 percent interest, it wouldn’t make sense to pay more than $98.
Economists call this latter concept a discount rate. And it plays an important role in the financial sector. For example, when the US government wants to borrow money for a year, it auctions off a Treasury bill: a promise to pay a fixed amount (like $100) a year in the future. Currently, the yield on a one-year treasury bill is about 2 percent, meaning that you can pay around $98 now to get a government promise of $100 in one year.
When you buy a share of stock, you’re doing something similar: buying a share of the company’s future profits. Sophisticated investors use discounting to value a stock. Future profits get “marked down” using a discount rate that’s based on current and expected interest rates.
The further out you look, the more impact discounting has. At a discount rate of 2 percent:
- $100 of 2023 profits is worth $98.00 today.
- $100 of 2024 profits is worth $96.04 today.
- $100 of 2025 profit is worth $94.12 today.
Profits many years in the future are highly sensitive to discounting:
- At a 2 percent discount rate, $100 in 2032 is worth $81.71.
- At a 4 percent discount rate, $100 in 2032 is worth $66.48.
- At a 6 percent discount rate, $100 in 2032 is worth $53.86.
Suppose you’re thinking about investing in a startup that expects to turn a $100 million profit in 2032. How much is that future profit worth today? If interest rates are 2 percent, you’d want to discount those profits by 2 percent and value them at $82 million. At 4 percent, the same profits are worth only $66 million. At 6 percent, it’s $54 million.
So when interest rates rise, we should expect the value of stocks to fall even if nothing has changed about their future profit potential. And we should expect some stocks to be affected much more than others.
Wall Street analysts distinguish between “value” companies—those with a low ratio of stock price to earnings—and “growth” companies with a high price-to-earnings ratio. As the name implies, investors pay a premium for growth stocks because they expect their earnings to grow over time. When interest rates rise, we should expect growth stocks to fall more than value stocks, because a large share of their expected profits are far out in the future.
That description fits all of the companies I mentioned at the start of this piece: Snap, Tesla, Airbnb, Block, Uber, and Lyft. Some of these companies are still struggling to turn a profit at all, while others have been profitable for a number of years. But all of them have enjoyed healthy revenue growth in recent years. And Wall Street is pricing all of them as if they will enjoy strong earnings growth in the future.
And indeed, growth stocks have suffered larger declines in share price than value stocks over the last six months. Vanguard’s growth index fund, for example, is down about 27 percent since November. In contrast, the Vanguard value index fund is only down 3.4 percent.
Of course that might be partly because markets expect the next recession to reduce the profits of growth companies more than value companies. That’s probably true for Snap, which gets a lot of its revenue from the volatile ad market. But we should expect to see a similar effect even for growth companies that are not especially exposed to recessions, simply because rising interest rates make longer-term profits less valuable in present terms.
Startups are like extreme growth stocks
Last week the startup accelerator Y Combinator sent an email to companies in its portfolio.
“No one can predict how bad the economy will get, but things don’t look good,” the company wrote. “It’s your responsibility to ensure your company will survive if you cannot raise money for the next 24 months.”
Last month, Crunchbase News reported that global venture capital investment had declined in the first quarter of 2022, the first time this has happened in several years. Some of the biggest names in the venture capital world—including Softbank and Tiger Global—have started drastically cutting back on their investments. And things will only get worse if it becomes clear we’re headed for a recession.
Here too, an environment of rising interest rates plays an important role. A startup is the most extreme type of growth stock. A successful startup might have no profits for its first five or 10 years, then enjoy rapidly rising profits for 10 or 20 years after that.
And this means that the market value of a startup is highly sensitive to prevailing interest rates. If a venture capitalist thinks your startup is going to generate $100 million in profit ten years from now, it matters a lot whether she’s discounting those profits at 2 percent, 4 percent, or 6 percent.
The goal of any venture capitalist is to help a startup reach a liquidity event—either an acquisition or an initial public offering. That allows venture capitalists to cash out their investments and pay back the limited partners who supplied the money in the first place.
Publicly-traded companies like Tesla and Uber serve as benchmarks for investors thinking about investing in younger startups. If Wall Street values such “recently graduated” startups highly, venture capitalists are going to be more willing to plow money into companies that could be the next Tesla or Uber.
When growth stocks crash, on the other hand, that sends shockwaves backwards through the whole startup ecosystem. If the best-case outcomes for startups get less lucrative, investors are going to be a lot choosier about which startups are worth funding. At the same time, rising interest rates mean that investors will discount the profits from future exits more heavily.
And that’s a problem because a lot of people in recent years have founded startups assuming they’d have little trouble raising multiple rounds of financing before they reach profitability. If venture capitalists suddenly shut their wallets—or start to offer much less generous financial terms—startups could find themselves with too little runway to reach profitability before they run out of money.
In a sense, this is how things are supposed to work. The Fed had to raise interest rates because spending across the economy was outstripping the supply of goods and services, leading to high inflation. One way higher interest rates will help to “cool down” the economy is by slowing the flow of venture capital into Silicon Valley, which in turn will mean tech startups hire fewer programmers, rent less office space, purchase fewer catered lunches for their employees, and so forth.
All of which will ease inflationary pressures at the margin. But the process will be painful—especially for those who will lose their jobs because their companies can’t raise another round of funding.