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With the rise in Inflation all across the globe and a halted stock rally, tech stocks are the first casualties. A sector that witnessed a tremendous boom throughout the pandemic is now tanking, be it here in India in form of the latest tech IPOs faltering or a downturn in American tech stocks.
The Downturn in US Tech Stocks
The Nasdaq Composite and the tech sector of the S&P 500 slid sharply to begin the year. Major tech stocks such as Apple, Google, Facebook, etc. witnessed a correction in the first two weeks of trading in 2022.
Why have tech stocks fallen? Many on Wall Street blame the Federal Reserve and bond yields. Minutes of the December meeting of the Federal Open Market Committee suggest the Fed is headed for earlier, faster rate hikes, and more aggressive policy tightening. As part of that, the central bank is set to normalize—read: shrink—its balance sheet, which has ballooned to nearly $9 trillion amid the Fed’s pandemic-era program of quantitative easing, which adds liquidity to markets. Indications of the Fed’s next moves, as well as its view of a strong U.S. economy, were good for bond yields. Following the release of the Fed minutes, the yield on the benchmark 10-year U.S. note spiked. It was even higher Thursday at nearly 1.75%, having started the week at just 1.53%.
Interest rate hikes, less liquidity in markets, and higher bond yields are all bad news for tech stocks. Large technology companies often have lofty valuations based on assumptions about their profitability going far into the future. Investors tend to accept those higher valuations more easily when interest rates are extremely low, giving them fewer alternatives for returns. With interest rates poised to rise, investors are rethinking the high valuations they put on tech giants. Elevated yields, in particular, tend to discount the present value of future cash flows—and the valuations of many tech stocks are reliant on the notion of profits well into the future.
In December 2021, CNBC identified 55 tech companies that debuted in the U.S. last year through an IPO, special purpose acquisition company, or direct listing. Only one of them — GlobalFoundries — is less than 20% off its high price. According to CNBC, that means the rest are in the bear market territory, typically defined as a drop of 20% or more from their peak. Ten of those companies have slid by at least that much in just the last week. CNBC also noted that 23 of those companies have lost half or more of their value since reaching their highs, including Robinhood, which has plummeted 74% from its top in early August, and LegalZoom, which has plunged 58% since peaking in July (prices from December 2021).
Indian Tech Scenario - A Tale of Two Faltering Tech IPOs
While the shares of Nykaa, the Indian online beauty retailer, listed at a premium of 79 percent to the issue price, marking a strong listing for the Falguni Nayyar-led startup, Paytm and Policybazaar, two major tech companies, which debuted on stock exchanges with lofty valuations have now lost significant value since their debut.
PB Fintech, the parent company of Policybazaar is currently trading at 940 and is down 36% from its all-time high of 1470 in November. The shares price of the startup listed on the BSE and NSE in November at INR 1,150, at a premium of 17.35%.
Paytm has lost nearly 51% since listing, eroding over Rs 70,000 crore of its market value. At the initial public offering (IPO) price, the firm was worth Rs 1.39 trillion. The fall in Paytm’s share price can be attributed to its bloated evaluation at the time of IPO and the impact of the Federal Reserve’s stance on Inflation.
Paytm demanded a 47x price to sales during its IPO and currently trades at 26x because of the correction in its stock price. The high valuation was sought despite the stiff competition in each of its business segments without market leadership in any one of them. Recent indications that the US Federal Reserve may increase interest rates earlier than had been foreseen have impaired the valuations of new age/tech companies across the globe.
"Fed tightening and increased tapering are definitely playing out on high valuations. The biggest effect has come on some of the new age, new tech companies in the US and also in India" said Aditya Kondawar, chief operating officer of JST Investments.
"Some new-age companies demanded a price to sales valuation of 40-70 times during their IPOs! It is expected that as major central banks across the globe go on a rate hike cycle, exorbitant valuations in some pockets of the market are expected to cool down", Kondawar added.
Why Inflation is Bad News for Tech Stocks
(Image Credits: Capital.com)
To combat inflation, many governments increase the interest rates their central banks charge. Higher interest rates attract more consumers and businesses to put more money in higher-yield bonds and savings accounts -- which temporarily cools off a country's economic growth and slows down the inflation rate. But higher interest rates can hurt growing tech companies in three ways.
First, they increase the costs of borrowing more money to expand a business. That's bad news for high-growth tech companies, which are burning cash with widening losses.
Second, it reduces the long-term estimates for a company's earnings and free cash flow growth. That reduction, which can be calculated with the discounted cash flow model, hurts high-growth companies, which are valued based on their future FCF growth instead of their near-term profits.
Therefore, unprofitable tech companies that are trading at frothy valuations usually suffer the most as interest rates rise. Lastly, higher interest rates turn bonds into safer investments for big institutional investors. Therefore, it's common to see a lot of money rotate from the tech sector into the bond market as yields rise.