FRBSF Economic Letter
2000-15; May 12, 2000
Three Questions about "New Economy" Stocks
From January 1995 through the third week of April 2000, the Dow Jones
Industrial Average (DJIA) advanced a respectable 184%. Even though this
venerable index has included tech firms over the last few years--most
recently Intel and Microsoft in 1999--it still is taken by many to represent
the industrial heavyweights of the so-called old economy. In sharp contrast
to the DJIA, the S&P technology index--which represents the so-called
new economy stocks--shot up 624% during the same period. As a result,
the differences in valuations between the old economy stocks and the new
economy stocks are striking. Even after the enormous stock market decline
in the second week of April, the price of technology stocks still was
averaging 62 times earnings, while the price of stocks in the DJIA was
averaging 23 times earnings.
This Economic Letter addresses three questions about new economy
stocks versus old economy stocks. First, how dominant are technology companies
in the stock market, and how important are they in our economy beyond
the stock market? Second, do the valuations of technology stocks make
sense, given market expectations and underlying fundamentals? Third, how
sensitive are technology companies to interest rate changes?
Dominance of technology companies
For the purposes of this analysis, the technology sector is defined to
include the following industries: biotechnology, communications equipment,
computer software and services, computer hardware, computer networking,
computer peripherals, semiconductors, semiconductor equipment, cellular
and wireless telecommunications, and Internet companies. Due to data availability,
only publicly traded companies are used in the analysis.
Four measures are used to gauge the dominance of technology companies:
market capitalization, total assets recorded on the balance sheet, employment,
and net sales. In terms of market capitalization, the technology sector
accounted for only 7% of the total stock market value back in 1990. With
the big jump in market valuation of tech stocks during the last ten years,
tech stocks made up 36% of total stock market capitalization as of March
2000--more than a fivefold increase.
How dominant are tech companies in the economy beyond the stock market?
In terms of balance sheet assets, they play a relatively small role. Among
all publicly held nonfinancial companies, the total assets controlled
by technology companies was a mere 9% in March 2000 (it was 6% in 1990).
The data on employment and annual sales are available only through 1998.
They show that the number of employees in the technology sector accounted
for only 7% of total employment among public companies in 1998, up from
6% in 1990. And in terms of sales, technology companies accounted for
10% of total sales by all publicly traded nonfinancial companies in 1998,
up from 6% in 1990. These measures indicate that while technology companies
account for more than one-third of the total stock market capitalization,
they account for less than one-tenth of total assets, employment, and
sales in the economy.
Quite clearly, the high valuation of tech stocks reflects investors'
willingness to pay a high premium for their future growth opportunities.
The question is: How fast must technology companies grow their earnings
to justify their current price-earnings (P/E) ratios, which currently
average about 62? Let us assume that investors require a 15% annual return
for holding technology stocks. In order to bring the P/E ratio of technology
companies down to a more sustainable 30 in, say, three years, a back-of-the-envelope
calculation suggests that technology companies must be able to generate
average annual earnings growth of 46%. To bring the P/E ratio down to
30 in five years, technology companies still need to grow earnings at
a rate of 33% per year; and even given 10 years, the required earnings
growth is 24%.
How realistic are these expectations? Figures 1-3 provide some answers
by displaying earnings, net sales, and operating income comparisons for
tech and non-tech companies; note that the scale measuring tech performance
is one-tenth the scale for non-tech performance. Figure
1 shows the aggregate earnings of all publicly traded technology and
non-technology companies from 1990 to 1998. Between 1994 and 1997, when
the technology sector was reporting healthy profits, the compound average
annual earnings growth rate for these companies was only 7.7%. Ironically,
non-technology companies reported faster earnings growth during the same
period, at an average annual rate of 11.8%. In terms of sales growth,
Figure 2 shows
that between 1990 and 1998, technology companies' sales growth was more
than double that of non-technology companies: 11.7% for the techs versus
5% for non-techs. Turning to operating income, i.e., earnings before interest,
tax, and depreciation, Figure
3 shows that operating income at technology companies grew at 10.4%
between 1990 and 1998, versus 6% for non-techs. Taken together, compared
to non-techs, tech stocks have very high P/E multiples, which implies
extremely high earnings growth expectations by the market. In terms of
fundamentals, technology firms have had slower earnings growth, but much
faster sales growth, and somewhat faster growth in operating income than
Interest rate sensitivity
How will monetary policy, and hence changes in interest rates, affect
tech stocks? Some market commentators suggest that the tightening of monetary
policy would do little harm to tech stocks while damaging non-tech stocks
disproportionately. In particular, they assert that technology companies
are less sensitive to interest rate hikes because these companies tend
to rely much more heavily on equity financing than on debt financing.
To shed light on this, it would be useful first to examine the capital
structure of tech and non-tech companies and then to discuss the effect
of changes in interest rates on the value of a capital asset using the
discount cash-flow model.
Figure 4 shows
that, in the aggregate, the debt-to-asset ratio for technology companies
is much lower than for non-tech, nonfinancial companies, and that the
gap has been widening. In 1990, the aggregate debt-to-asset ratio for
techs was about half that of non-techs. By 1998, only 7% of tech firms'
assets were financed by debt, as compared to 27% for non-techs. This confirms
that technology companies tend to have much less debt in their capital
structure than do non-techs, suggesting that, other things being equal,
technology companies would be less sensitive to interest rate changes
than non-technology companies.
But other things are not equal. As discussed earlier, tech stocks tend
to rely on more distant future cash flows to support their current stock
prices than do non-tech stocks. Using the discount cash-flow model, an
increase in interest rates will lower the present value of future cash
flows. More importantly, for a given interest rate increase, the more
distant the future cash flow, the bigger the drop in its present value.
This implies that tech stocks still could be sensitive to interest rates
if they rely on more distant future earnings to support their current
To sort out the net effect of changes in interest rates on tech stocks,
the standard two-factor model that is well known in academic research
is estimated. Specifically, individual stock returns are regressed against
the market return and the percentage change in the 10-year Treasury bond
yield, using daily data from 1980 to 1998. The results show that after
controlling for systematic stock market movements, technology stocks in
general are not sensitive to interest rate changes. Some non-technology
stocks, however, such as financials and utilities, are quite sensitive
to interest rate changes even after controlling for the market effect.
The results suggest that increases in interest rates will drag down the
broad stock market but are not expected to have any additional effects
on tech stocks. That is, the effects of higher interest rates on tech
stocks are expected to be about the same as those for the overall market.
Short answers on "new economy"
To sum up this exercise, I will review the three questions and answers
addressed in this Economic Letter.
Q: How dominant are technology companies?
A: Technology companies dominate in terms of market capitalization,
but not in terms of tangible assets, employment, and sales.
Q: Do the valuations of technology companies make sense?
A: Tech stocks look very richly priced, especially in light of their
demonstrated fundamentals. While there is no question that many technology
companies are high achievers, the kind of future earnings growth expected
by the market is still quite daunting.
Q: How sensitive are tech stocks to interest rate changes?
A: Research suggests that technology stocks are not sensitive to interest
rate changes after controlling for systematic stock market movements.
With tech stocks accounting for a large share of the stock market, at
sky-high valuations, any wealth effects stemming from the stock market
can be largely attributable to technology companies. However, can monetary
policy be used to bring down these high fliers? The answer appears to
be "no"--not without bringing down the entire market. This suggests
that targeting stock prices may not be an effective policy approach. Rather,
targeting inflation with an eye on the wealth effect seems to be the better
policy to pursue.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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