Stocks woke up on the wrong side of the bed to start 2022. The S&P 500 briefly flirted in “correction” territory (a drop of at least 10% from an all -time high), and the Nasdaq dropped sharply. more as high -flying Tech stocks have been hit particularly. The levy is blamed against the Federal Reserve because it implies raising interest rates this year in an attempt to fight inflation.
As a result, some market pundits and TV personalities are urging investors to sell stocks that are losing money this year as the Fed begins to tighten its monetary policy. This sounds like good advice, but it’s not as simple as it says. Negative earnings do not always indicate that a company is “losing money,” and even a rising interest rate environment is not the end of the world for growing high -quality businesses.
Photo source: Getty Images.
What is the deal with interest rates and stocks?
Before analyzing what actually makes a company profitable, what do interest rates have to do with the stock market? It all has to do with the different equations used behind the scenes to value a company. A business is generally valued based on its ability to generate future revenue (sometimes referred to as cash flows).
Many of those equations rely on existing interest rates to put a present value into future earnings. A higher interest rate (which generally implies a higher cost for a company to access the cash it needs to fund operations) thus lowers the current amount of revenues, which can lower the price of a stock. Not surprisingly, Warren Buffett compared interest rates to gravity for financial assets.
Sell stocks that are losing, but …
The advice to sell stocks that are losing money makes sense in this context because we can jump to the conclusion that a company that is losing money needs to borrow money. And for a high-growth company that is expected to see substantial revenue increases, rising interest rates could cause stock prices to fluctuate as the market re-evaluates the merits of its ownership.
But there are some caveats to this argument. For one thing, just because a company is losing money doesn’t mean it needs to raise money. Dozens of new, small companies have had IPOs in recent years and have raised hundreds of millions (or even billions) in cash and no debt. They can afford it incidentally work at a loss for many years by using cash on hand balance if they can grow their businesses at a rapid rate.
This is the business model Amazon (NASDAQ: AMZN) helped with development as it aggressively spent years to build itself on the e-commerce and cloud computing titanium it has today. Typically, little or no profit today can equate to larger profits in the future.
YCharts data.
Also, it’s important to note that marquee revenue values that often get media attention don’t necessarily indicate how profitable a company is currently. Net income and earnings per share are prepared using generally accepted accounting principles (GAAP), but this measure often includes many non-cash costs such as depreciation and amortization of purchases the company has made. in the past.
For many companies, therefore, other metrics such as free cash flow or EBITDA (earnings before interest, taxes, depreciation, and amortization) are paramount in measuring current profitability. It was taught recently by Service Today (NYSE: NOW) CEO Bill McDermott on the cloud computing company’s recent revenue call. Net income may seem very thin right now, but ServiceNow actually operates on a very good free cash flow profit margin and there is no need to tap into the capital markets to raise money. Raising interest rates wouldn’t be that big of a deal for stocks like ServiceNow.
YCharts data.
But what about stocks with valuation premiums that are expected to report large increases in future earnings (and thus have stock prices that are very sensitive to interest rates)? Rising interest rates is also not a deal-breaker for owning those stocks. Alphabet (NASDAQ: GOOGL)(NASDAQ: GOOG) is just a case in point. When the Federal Reserve tightened its monetary policy in the last round from late 2015 to mid-2019, many “overpriced” stocks did more than well. If a company continues to expand thanks to secular growth trends, higher rates are more than just short -term bumps in the road.
Chart: Federal Reserve Bank of St. Louis.
YCharts data.
However, rising interest rates are likely to cause some volatility in the stock market this year, perhaps even temporarily tanking some stocks by steep double-digit percentages at times. But what else is new? There is always volatility when investing in stocks. Interest rates are the latest scapegoat for market turmoil. Give your stock holdings a serious look, but just because a business is “losing money” doesn’t mean you have to sell it.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a premium Motley Fool counseling service. Let’s be motley! Asking an investing thesis-at least one of us-helps all of us think critically about investing and make decisions that will help us become smarter, happier, and richer.