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Why are ASX tech shares like Afterpay (ASX:APT) so volatile?

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For anyone who is invested in ASX tech shares, or even just watches them for fun (you know who you are), volatility is a constant companion. Whenever the S&P/ASX 200 Index (ASX: XJO) moves around, you can almost always count on ASX tech shares moving around more. And on those days, it’s often in the opposite direction to the general market as well.

Take yesterday. Yesterday, the ASX 200 gained a modest 0.6% over the trading day. Yet tech shares like Afterpay Ltd (ASX: APT) and Xero Limited (ASX: XRO) were both down more than 2% each. Year to date, the ASX 200 is currently (at the time of writing) up roughly 1.1%. Yet Xero is down more than 19% over the same period. Afterpay was up around 33% at one point last month (10 February). But today, Afterpay is down ~2% year to date. Swings like this are very common with most ASX tech shares, whether that be Zip Co Ltd (ASX: Z1P) or WiseTech Global Ltd (ASX: WTC).

So what gives?

P/Es and cash flows

It is possible that the relatively extreme volatility we see in the ASX tech space comes from the way ASX shares are often valued by professional and institutional investors (who are the ones who move the markets most of the time). It’s pretty easy to work out what a mature business that generates positive cash flow will earn its investors. Take Transurban Group (ASX: TCL). Transurban operates toll roads, which have a set pricing scheme, and fairly predictable traffic volumes backed up by lots of historical data. Thus, it’s pretty easy to (roughly) work out how many vehicles will use Transurban’s roads, and by extension how much money will flow to the company.

But it’s a whole different kettle of fish with tech shares. Many tech shares aren’t even profitable on a statutory basis. That’s why Afterpay doesn’t yet have a price-to-earnings (P/E) ratio. When it comes to the tech space, investors are usually trying to value the fastest-growing companies based on what their future cash flows might be, not what they are delivering this year (or next year for that matter). That’s why the market is happy to assign a (seemingly sky-high) P/E ratio of 500 to Xero. It’s expecting Xero to earn way more in the future than what it earns today.

ASX tech shares are hard to value

But basing a company’s current valuation on what it could deliver years down the track is fraught with risk. None of us knows what the future holds at the best of times. Thus, small changes to the regulatory or economic environment today can have big implications in 3 or 5 years. With a company like Transurban, it’s a lot easier to work out what those changes might do to the company because we can see immediate effects on its mature cash flow. But with a fast-growing company with nothing more than a promising pipeline of potential profits, it gets a lot murkier.

It could be for this reason that the valuations of ASX tech shares move around so much. It’s just harder to predict how profitable a company will be in the future if that company isn’t making profits today.

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Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of ZIPCOLTD FPO. The Motley Fool Australia owns shares of AFTERPAY T FPO, Transurban Group, WiseTech Global, and Xero. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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