Technology stocks have been the driving force behind the longest-running bull market in history.
The technology sector is vast, comprising gadget makers, software developers, wireless providers, streaming services, semiconductor companies, and cloud computing providers, to name just a few, according to Motley Fool. Any company that sells a product or service heavily infused with technology likely belongs to the tech sector.
And, the pandemic has been mostly positive for the tech industry. Companies like Amazon have thrived as consumers shifted hard toward e-commerce. Additionally, companies like Microsoft have also done well, buoyed by demand for collaboration software, devices, gaming, and cloud computing services as people spend more time at home.
Many of the most valuable companies in the world are technology companies.
Growth stocks have outperformed for 12 years and counting. Since the end of the Great Recession in 2009, growth stocks have been a driving force on Wall Street. Many of the most valuable companies in the world, like Apple and Microsoft, are technology companies.
Historically low lending interest rates and the Federal Reserve’s ongoing quantitative easing measures have created a pool of abundant cheap capital that fast-paced businesses have used to expand operations and investors have used to fuel the longest running bull market.
Technology stocks have been a key component of the market’s rising trend. Since the financial markets collapsed, demand for consumer electronics and related products and services has caused the tech sector to far outperform every other segment.
However, revenue growth is starting to slow, although the delta variant surge may drive consumers away from stores once again. The economic dynamics favoring technology’s 12 year growth are changing.
Inflation is running rampant, and the Federal Reserve has indicated it’s become more hawkish on fighting it, indicating as many as three interest rate hikes may be in the cards calendar year 2022, effectively ending its loose money policy. Higher interest rates hurt growth stocks because growth stocks intrinsic value is based on the value of their future earnings. And, those future earnings are not worth as much if interest rates go up.
To best analyze tech stocks, first determine if the company is profitable or not.
For mature tech companies that produce profits, the price-to-earnings ratio is a useful metric. Divide stock price by per-share earnings and you get a multiple that tells you how highly the market values the company’s current earnings. The higher the multiple, the more value the market is placing on future earnings growth.
Many tech companies aren’t profitable, so the price-to-earnings ratio can’t be used evaluate them.
Revenue growth matters more for these younger companies.
If you’re investing in something unproven, you want to make sure it has solid revenue growth.
For unprofitable tech companies, it’s important that the bottom line be moving from losses toward profits.
As a company grows, it should become more efficient, especially when it comes to the sales and managing expenses. If it’s not, or if spending is growing as a percentage of revenue, that could indicate something is wrong.
Ultimately, a good tech stock is one that trades at a reasonable valuation given its growth prospects.
Accurately figuring out those growth prospects is the hard part. If you expect earnings to skyrocket in the coming years, paying a premium for the stock can make sense. But if you’re wrong about those growth prospects, your investment may not work out.
Thus, investing in technology stocks can be risky, but you can reduce your risk by investing only when you feel confident their growth prospects justify their often lofty price to earnings valuations.
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