Stocks woke up on the wrong side of the bed to start 2022. The S&P 500 briefly flirted with "correction" territory (a drop of at least 10% from all-time highs), and the Nasdaq is down even more as high-flying tech stocks were hit especially hard. Blame is being levied against the Federal Reserve since it's hinted at raising interest rates this year in an attempt to combat inflation.
As a result, some market pundits and TV personalities are urging investors to sell stocks that lose money this year as the Fed starts to tighten its monetary policy. It sounds like good advice, but it isn't as simple as it sounds. Negative earnings don't necessarily indicate a company is "losing money," and even a rising interest rate environment isn't the end of the world for growing high-quality businesses.
What's the deal with interest rates and stocks?
Before delving into what actually makes a company profitable, what do interest rates have to do with the stock market? It all has to do with the various equations used behind the scenes to value a company. A business is generally valued based on its future ability to generate profits (sometimes referred to as cash flows).
Many of those equations rely on prevailing interest rates to place a present value on those future profits. A higher interest rate (which generally indicates a higher cost for a company to access cash it needs to fund operations) thus lowers the present value of profits, which in turn can lower the price of a stock. It's no wonder that Warren Buffett compared interest rates to gravity for financial assets.
Sell stocks that lose money, but...
The advice to sell stocks that lose money makes sense in this context since we can jump to the conclusion that a company that loses money must have to borrow money. And for a high-growth company that is expected to see a dramatic rise in profits, rising interest rates can cause stock prices to go haywire as the market reassesses the merits of owning it.
But there are a couple of caveats to this argument. For one thing, just because a company is losing money doesn't mean it needs to raise cash. Dozens of new, small companies had IPOs in recent years and raised hundreds of millions (or even billions) in cash and have no debt. They can afford to intentionally operate at a loss for many years by using up that cash on hand balance if they can grow their businesses at a rapid rate.
This is the business model that Amazon (AMZN -3.66%) helped flesh out as it spent aggressively for years to build itself into the e-commerce and cloud computing titan it is today. Basically, little to no profit now can equal a great deal more profit later on down the road.
Also, it's important to remember that the marquee earnings figures that often grab media attention are not necessarily indicative of how profitable a company is in the present. Net income and earnings per share are prepared using generally accepted accounting principles (GAAP), but this metric often includes a lot of non-cash expenses like depreciation and amortization of company purchases made in the past.
For many companies, then, other metrics like free cash flow or EBITDA (earnings before interest, tax, depreciation, and amortization) are far more important in measuring current ability to generate profit. This was recently pointed out by ServiceNow (NOW -2.52%) CEO Bill McDermott on the cloud computing company's recent earnings call. Net income may appear to be very thin at the moment, but ServiceNow actually operates at a very healthy free cash flow profit margin and has no need to tap into capital markets to raise cash. Rising interest rates are not going to be that big of a deal for stocks like ServiceNow.
But what about stocks with premium valuations that are expected to report big increases in profits down the road (and thus have stock prices very sensitive to interest rates)? Rising interest rates aren't a deal-breaker for ownership of those stocks either. Alphabet (GOOGL -1.30%) (GOOG -1.38%) is just one case in point. When the Federal Reserve tightened its monetary policy the last go-around from late 2015 to mid-2019, plenty of "overpriced" stocks did more than just fine. If a company is steadily expanding thanks to secular growth trends, higher rates are little more than short-term bumps in the road.
Nevertheless, rising interest rates are likely to cause some stock market volatility this year, perhaps even temporarily tanking some stocks by steep double-digit percentages at times. But what else is new? There's always volatility when investing in stocks. Interest rates are just the latest scapegoat for market turbulence. Give your stock holdings a serious look, but just because a business is "losing money" doesn't mean you need to sell it.