• AUGUST 29, 2000

Will crude prices affect technology stocks?

Ofcourse not. Well that's what most of us think instinctively. However, go a little deeper and one realizes that there could be several issues, which could have significant effects on this sector.

First and foremost, one needs to understand how a stock is valued. Among the most popular methods is the discounted cash flow (DCF) method, which values stocks in terms of the future cash flows that are likely to be derived form it. Future cash flows are discounted to the present by using a factor that depends on among other things the expectations of the investor. It is while determining this, that a rise in crude prices (i.e. higher inflation) will have an impact. A higher inflation would result in an investor demanding a higher return (to atleast maintain his real return). This would lower the present value of cash flows to be derived from the stock, as a result of which the stock, at its current valuations, would seem relatively less attractive.

Higher inflation would also have some connotation from the point of view of the competitiveness in the international markets. Higher inflation would contribute to a smoothening of the competitive edge enjoyed by Indian companies in the international markets, as domestic prices rise. Although the effect would be minimal given the strong demand, in the longer term, persistent inflation could jeopardize the sector's growth prospects, as competitor nations like China take the lead.

Then is the question of valuations, although more theoretical in explanation. Suppose, the technology stocks trades at a P/e multiple of 100 (industry average) and the old economy stocks trade at a multiple of 5. There is a status quo in the markets. Now when crude prices jump, it is the old economy stocks that are hit the most (as they are the ones that consume large quantities fuel) and consequently their valuations suffer. In effect what has happened is that the rift between technology and old economy stocks has widened. Such a situation would definitely make the technology stocks seem more highly valued. And given the fact that the sentiment in the markets would be adversely affected by the rise in crude prices, valuations of technology stocks too could correct.

Therefore to say that technology stocks would be unaffected by crude prices is not correct. Rather it would be one of the sectors that will be relatively less affected by the rise in crude prices.

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