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If you're a fundamental investor, you should view a stock as a fractional ownership stake in a company. The value of this company should be equal to the net present value (NPV) of the future cash flows that will be produced for the owners (in this context, the "owners" are the shareholders vs. the "lenders" being the debt holders).

An important nuance of this concept is that we are dealing with the NPV of the cash flow stream. The NPV allows us to measure how much the cash flows of the future are worth to us today1. An indisputable law of investing is that a lower discount rate will always result in a higher NPV. Let's pretend we have an annuity that pays $1,000 per year forever. The value of this asset is $10k if our discount rate is 10%; however, the value of this asset would jump to $50k if our discount rate was only 2%.

A low discount rate also diminishes the impact on value associated with the timing of the cash flows. For example, a $100 cash flow that will arrive 50 years from now is worth $100 today if we use a discount rate of 0%. Conversely, a $100 cash flow that will arrive tomorrow is also worth $100 today. The key point is that a very low discount rate will blur the lines between the value of cash flows today versus cash flows in the future.

Bernanke Capital Management has spent the past 5 years driving down interest rates to historic lows.

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The lower interest rate, namely the 10 year Treasury yield, is an input used by investors to determine the value of companies in the stock market. As we demonstrated in the above example, extremely low discount rates will cause investors to make little distinction between imminent cash flows and cash flows in the distant future.

What kinds of companies produce meager cash flows today but promise great cash flows far out into the future?

The answer is growth companies. We posit that growth companies (i.e. social networking, "cloud", SaaS, 3-D printing, biotech, etc.) have been huge beneficiaries of the low interest rate world. The market has had little discernment between cash flows that are being generated today versus cash flows that are promised to arrive in 2025. We think this has resulted in many mispriced individual securities. Even at an index level you can see the "growth" divergence that has occurred this year.

Russell 2000 Growth (NYSEARCA:IWO) vs. Russell 2000 Value (NYSEARCA:IWN)

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What happens when interest rates rise?

Well, basically the opposite of what has been going on. Near-term cash flows will become relatively more valuable than distant future cash flows. We ran the following hypothetical analysis to demonstrate our point. The exhibit is a bit noisy but here's the premise: we created a DCF model for two companies that have the same capital structure (100% equity, no debt) and the same business risk (beta of 1.0). We modeled out twenty years of cash flows and assume that both companies reach a steady-state in 2033 that is used to calculate the terminal value.

Both stocks have intrinsic values of exactly $100 today based on our completely accurate crystal ball. The only difference between these companies is the timing of the cash flows. Sexy Growth Inc. generates negligible cash flows today but will produce much larger cash flows in the future. Boring Value Corp is a mature company that generates its cash flows today but with much less future growth.

Our discount rate (via risk-free rate) is based on the current 10 yr Treasury yield of 2.90%.

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As you can see, both stocks have intrinsic values of $100 but what happens when interest rates rise and our discount rate increases?

Predictably, both stocks decline in value because the NPV of their cash flows will drop due to a higher discount rate. What is interesting is the difference in magnitude of these declines. If the 10 yr Treasury yield were to rise to 5%, the value of Sexy Growth Inc. would drop by -50% just from the increase in the discount rate alone. This makes perfect sense because the cash flows further out in the future would be worth less on an NPV basis. The price of Boring Value Corp would also drop but by a lesser degree.

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Here is a look at how Sexy Growth Inc and Boring Value Corp would perform based on different interest rates:

The higher interest rates go, the more Sexy Growth Inc will underperform. This analysis assumes no changes in the economy or operating environment; it only isolates the impact of Bernanke Capital Management's financial engineering.

Trade Ideas:

Using this context, we think it's clear that a lot of the 2013 stock market rally was driven by QE-induced low interest rates. Growth stocks with little or no earnings/cash flows but grandiose promises for the future were the big beneficiaries. With the QE tapering under way and interest rates rising, we expect insanely valued growth companies to underperform in 2014.

Our favorite measure of "insanely valued" is to combine large absolute enterprise values (over $5b) with high revenue multiples. The sheer size of these companies makes the stock price harder to support long-term and buyouts are less likely because there are fewer buyers able to digest them.

We see the worst offenders being Facebook (NASDAQ:FB), Workday (NYSE:WDAY), TripAdvisor (NASDAQ:TRIP), 3D Systems (NYSE:DDD), Splunk (NASDAQ:SPLK), NetSuite (NYSE:N), ServiceNow (NYSE:NOW), Stratasys (NASDAQ:SSYS). These stocks have been absolute "widow makers" for short sellers but we think the tide could turn dramatically if interest rates continue to rise.

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1In order to conduct an NPV calculation, we need to determine the correct discount rate that adequately captures the risk and opportunity cost of our investment's cash flow stream. The Capital Asset Pricing Model (CAPM) is the industry standard for determining the discount rate for equity valuation.

Source: The Easiest Trade Of 2014: Long Value/Short Growth

Additional disclosure: The author and/or employer may buy or sell shares in any company mentioned, at any time, without notice. The information contained herein is believed to be accurate as of the posting date. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information. This article represents best efforts to convey a fact-based opinion. Our conclusions may be incorrect. This is not a recommendation to buy or sell any securities. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of the Author.