One of the most extraordinary developments that have taken place over the past 18 months is the outstanding performance of some technology stocks.
I am not talking about highly speculative technology stocks, but instead referring to businesses like Apple (AAPL, Financial) and other high-quality names that have shot up in value.
In part, this performance was due to the pandemic-induced sell-off, which occurred in March of last year. The sell-off took all sections of the market by surprise, even though technology companies were set to benefit.
The resulting rally reflected the recovery in valuations to pre-pandemic levels and the growth these businesses had experienced during the pandemic.
The recovery also reflected the significant decline in interest rates the world experienced immediately after the pandemic began to spread around the world.
Stocks are cheap
Warren Buffett (Trades, Portfolio) explained the amazing development at this year's Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting. Referring to how the sudden drop in interest rates affected security prices, he said:
"If I could reduce gravity -- its pull -- by about 80%, I mean, I'd be in the Tokyo Olympics jumping...So you've had this incredible change in the valuation of everything that produces money, because the risk-free rate produces...nothing."
He went on to give an example. Before the pandemic, if Berkshire had invested $100 billion in U.S. Treasury bills, it would earn around $1.5 billion. However, at two basis points, the return would drop to $20 million, he explained. It would be like "your wages going from $15 an hour to 20 cents an hour."
Buffett continued to say that if the 10-year Treasury remained at its low pandemic level, companies like Apple "are a bargain."
Additionally, he explained that companies like Google (GOOG, Financial), Apple, and Microsoft (MSFT, Financial) are incredible companies in terms of what they earn on capital.
"They don't require a lot of capital and they gush out more money," he stated. Compared to Treasuries with interest rates of below 1%, they are incredibly attractive securities, even after their recent performances, the Oracle of Omaha explained.
Discount rates plunge
Interest rates have moved higher over the past few months, but the basis of what Buffett said remains true. Compared to the rate of return available on risk-free instruments, technology companies with high returns on invested capital continue to look like better investments. This is because they produce better cash flows and better returns.
Numbers can tell a better story than words, so here's an example.
Last year Apple generated $73 billion of free cash flow. Assuming the company's cash flow grows at 2% per annum for the next 60 years (a figure that is designed to reflect inflation) and using a discount rate of 2.5%, the company's terminal discounted market value is $3.8 trillion.
That example is designed to reflect pre-pandemic interest rates.
Fast forward to today, and the interest rate on the 10-year is 1.62%. Plugging this figure into the above calculation gives a terminal discounted present value of $4.2 trillion.
If I use the July 2020 10-year rate of 0.6%, Apple's terminal discounted market value jumps to $6.1 trillion, which is nearly three times more than its current market capitalization.
These figures are only designed to be an example. They should not be used for investment decisions. However, I think they clearly show how significantly a company's valuation can change with the substantial changes in interest rates we've seen over the past 12 months.
Of course, the big question is whether or not interest rates will remain at current levels. That is the trillion-dollar question.
Disclosure: The author owns no share mentioned.
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