Rising interest rates: is it a bad idea to buy growth stocks today?
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Since the start of the year, equities, especially growth stocks, have sold off significantly, in part due to the higher cost of borrowing due to rising interest rates. Is it a bad idea to buy growth stocks today? It depends. And here’s why.
Growth stocks encompass a wide range of stocks. Among them are technology stocks like Docebo (TSX: DCBO), which has yet to make a profit, and TELUS International (TSX: TIXT), which has profits. Rationally, it is safer to consider investing in the latter rather than the former, as the latter makes profits and the former loses money.
What do rising interest rates have to do with growth stocks?
Higher borrowing costs
Rising interest rates increase borrowing costs for businesses and consumers. Thus, businesses and consumers become more attentive to their spending. Companies are more cautious when investing in growth projects, which become less attractive due to higher costs and, therefore, lower expected returns. Ultimately, higher interest rates lead to slower economic growth.
It’s a good thing that Docebo has little long-term debt on its balance sheet. Its debt ratio (D/E) is around 44%, with nearly 92% of its debt being made up of current liabilities due within the year, mainly made up of deferred income (products and services that it must provide) and accounts payable. , which represent respectively 60% and 29% of its total debt. Its long-term debt ratio is only around 1%. Thus, it pays very little interest charges.
As a low-risk investment that pays off, TELUS International is therefore able to maintain a higher D/E ratio of 1.07 times. Its long-term debt ratio is also higher, at around 25%. That said, its interest charges are easily manageable with its earnings and cash flow.
Compression of stock market valuations
Docebo was growing its revenue at a high rate before the central bank began aggressively raising interest rates to counter high inflation. Revenue growth is no longer sufficient to maintain its high price-to-sales (P/S) ratio.
It has also benefited tremendously from the pandemic with revenue growth of 52% in 2020. Its P/S was 42.9 in 2020. It is estimated to be around 7.8 times this year with revenue growth of around 30 to 40%. Either way, compressing valuations will make it a bad idea to raise capital in the form of stock offerings. Due to quantitative tightening, capital raising on the financial markets contracted sharply.
Although TELUS International has been profitable, it has not been immune to the compression of stock valuations due to rising interest rates. In 2021, growth stocks traded up to +40 times earnings. At $25 and change per share, it trades at around 16.3 times earnings, which is much more reasonable for its expected earnings per share growth rate of around 11-13% per year over the next few years. .
The Takeaways of the Foolish Investor
Rising interest rates aren’t all bad. With this, investors can buy growth stocks at lower valuations at a cheaper price.
You can buy growth stocks if you limit their percentage in your portfolio. Appropriate growth stock allocation and portfolio diversification can help mitigate risk. The type of growth stocks you buy also makes a difference. Sticking to winning ones can help you sleep better at night and earn better risk-adjusted returns.
Between Docebo and TELUS International, the latter would be a better buy today, even if both are broke by higher interest rates.