Following the 2022 stock market correction, US growth stocks were hit the hardest by panic-selling investors. With the threat of rising interest rates putting an end to the era of near-free money, high-growth enterprises, especially in the technology sector, saw their valuations plummet.
Today, interest rates in the UK currently stand at 5.25%. And across the pond, the Federal Reserve has set them at 5.5%. Both are at their highest level in over a decade. And while the Fed and Bank of England have hit the pause on further rate hikes, there’s still a giant question mark over when eventual cuts might start taking place.
As such, both UK and US growth stocks continue to trade at unusually cheap levels. And as every investor knows, buying top-notch stocks at a discounted price is a proven recipe for building long-term wealth.
What do rate cuts mean for growth stocks?
In many cases, high-growth companies don’t typically rely on debt to fund expansion. Instead, they use the momentum of their share price to issue new stock, capitalising on the value of their equity. So why has more expensive debt crushed these valuations?
Without going too far into the weeds, the intrinsic value of a business is equal to the present value of its future cash flows. In other words, a company’s worth is equal to the amount of money it’s expected to make in the future, discounted back to today.
Interest rates directly impact this discount rate. Even a small change can lead to large swings in valuation. Therefore, as interest rates rise, value estimates fall. And since growth stocks already typically trade at lofty price tags, this translates into a rapid decline. That’s why so many US tech businesses saw their stock price plummet by 60%, 70%, and in some cases 80%, in the space of a few months in 2022!
However, the reverse is also true. Should interest rates start to fall, discount rates follow. That means higher valuation estimates leading to a potentially explosive growth in stock prices. That’s why 2024 might be a once-in-a-decade chance to get far richer.
A top stock to consider now?
Simply buying beaten-down enterprises in the hopes of a sudden upward correction isn’t a prudent strategy. After all, firms are unlikely to recover if their underlying fundamentals and long-term potential are lacking. Looking at my own portfolio, Shopfiy (NYSE:SHOP) is once again looking like a tempting pick.
The e-commerce giant powers millions of online storefronts worldwide. And with the firm taking a small fee on each transaction moving through its platform, the shares are set to benefit from both an interest rate cut as well as the return of consumer discretionary spending.
In fact, we’ve already started seeing evidence of the latter. In the group’s latest quarter, gross payments volume reached $45.1bn – a 32% jump versus a year ago. That translated into a free cash flow generation of $446m. And across the whole of 2023, free cash flow reached $905m versus $186m in 2022.
Despite this drastic improvement in its financial performance, Shopify shares continue to trade firmly below levels compared to a few years ago. While this may signal a buying opportunity, this depressed valuation may not be completely unjustified.
Amazon‘s continued expansion within the online retail space has some investors on edge about Shopify’s ability to capture and retain market share. And this intense competition has undoubtedly contributed to the stock’s volatility.
Yet given the scale of the e-commerce market, I think there’s plenty of room for multiple winners. And when paired with Shopify’s relatively low valuation, I believe the stock is primed for impressive long-term growth, especially at current prices.
This post was originally published on Motley Fool
