What's behind the drop in tech stocks? A model Wall Street uses to value stocks is flashing caution.

Tech stocks are in a correction. The Nasdaq 100, the largest 100 nonfinancial stocks in the Nasdaq, is 10% off the historic high it hit just three weeks ago, but many big names are down close to 20%.

Tech in correction
(% from 52-week high)

• Xilinx 23%
• PayPal 22%
• AMD 21%
• Nvidia 19%
• Apple 17%

What's going on? The market is worried interest rates will be shooting up and the Federal Reserve may not be able to control it.

Why would a rise in interest rates hurt stocks, particularly high-flying technology stocks?

It has to do with the way Wall Street values stocks. The market is a discounting mechanism: It is a way of trying to figure out what a future stream of cash flow — or earnings — is worth today.

This model, known as the Discounted Cash Flow model, is at the heart of the problem for technology stocks.

How DCF works

Stocks compete with other investments like bonds and cash. If you have $100 now, is it better to invest in stocks, bonds, cash or something else? Investors look at the time value of money. The sooner you own money, the sooner you can invest it. If I have $100 right now, and I can invest it and receive 2% today in a bond, that means I will have $102 next year. A hundred dollars a year from now doesn't help me, because I can't invest it.

What does this tell us? It tells us that a dollar today is worth more than a dollar in the future because that $100 has become $102 if I invest in a bond.

What is a dollar invested today worth in a stock that you might want to hold for, say, five years? Most stocks are valued based on how much cash they can generate in the future. Discounted cash flow uses a formula to figure out the present value of an expected stream of future cash flows.

That's not an easy thing to figure out. The first thing you need to do is figure out how much cash flow the company might generate, say one year from now.

The problem is, no one knows exactly how much cash a company is going to generate a year from now. It depends on many factors, including the economy, management, competition and the nature of the business. The further out you go, the harder it gets. It's much harder to estimate cash flow five years out then one year out.

Second, you have to make a guess on the discount rate. Simply put, what is the opportunity cost of owning alternative investments? That would be the minimum required rate of return you would accept. Usually, it is the prevailing interest rate.

Finally, you discount those expected cash flows back to the present day.

Discounted cash flow: An example

Here's a greatly simplified example. Suppose you have XYZ company that is generating $1 million in cash this year and is expect to generate the same $1 million in cash flow growth every year for the next five years:

XYZ: Cash flow projections

• Year 1: $1 million
• Year 2: $1 million
• Year 3: $1 million
• Year 4: $1 million
• Year 5: $1 million

Total cash flow over five years: $5 million

You have $5 million in cash flows. But wait: That is $5 million over five years. Is it really worth $5 million today?

It is not, because inflation erodes the value of money: $1 million in five years is not worth as much as it is today, or even one year from now.

So we need to discount what that future $1 million will be in present dollars. To do that, we need to make a guess about interest rates.

Let's say interest rates are 2%.

Using a complex formula, the discounted cash flow of that $5 million would be considerably less, say $4.71 million. In other words, when assuming interest rates of 2%, the value of that $5 million cash flow — the present value — is $4.71 million.

Here's the problem with rising rates and stocks: As interest rates go up, the present value of that $5 million goes down.

Let's say rates go from 2% to 4%, or even 6%. The discounted cash flow — the present value — of that $5 million would go down:

$5 million cash flow, 5 years
(present value)

• 2% interest: $4.71 million
• 4% interest: $4.45 million
• 6% interest: $4.21 million

The higher rates go, the lower the present value of that future stream of earnings.

It gets even worse when you are dealing with high-growth equities like many technology stocks.

That's because many tech stocks have rapid growth assumptions built into them. Instead of cash flows that would always be $1 million a year, for example, many would have expectations of growing 10%, 20%, 30% or more.

In this case, a rise in rates would eat into the present value of the investment even more.

Let's say that company is growing cash flow 10% a year for five years. Assuming a 2% interest rate, the present value after five years would be about $6.30 million, but change the interest rate to 4% or 6% and the numbers go down:

$5 million cash flow, 5 years
(present value, 10% growth)

• 2% interest: $6.30 million
• 4% interest: $5.93 million
• 6% interest: $5.59 million

This is an even bigger decline, on a dollar and percentage basis, than when there was no growth in cash flow.

Stocks compete with bonds

Peter Tchir of Academy Securities told me this was the heart of the problem: Higher rates lower the present value of the expected cash flow, and that means investors will be looking to pay less for a stock.

"Companies relying on future cash flow growth experience much greater risk as rates rise, and that has been the part of the market that has really driven returns in the stock market," he said. "That is why some parts of the market, like the Nasdaq 100, which is heavy in technology stocks, is getting hit much more than the Dow Jones Industrial Average, which has less companies expecting outsized growth."

The bottom line, Tchir says, is that bonds are competing with stocks as an investment, and bonds are starting to become more attractive: "If interest rates keep going up, I can make more investing in 10 year Treasurys than I could a week ago, and that makes other investments look less attractive."