You don’t have to look far to find high quality stocks that seem to have overshot their intrinsic value. As value-driven investors, we have two choices: use lower discount rates in order to justify investing in these stocks, or hold our cash and wait for better value to emerge.
One of the interesting features of the current low interest rate environment is the way it impacts on valuations for different types of businesses. Most people recognise that lower interest rates and discount rates imply higher equity valuations, but this effect is not felt equally by all companies. The companies most affected are those that have excellent prospects for long-term earnings growth.
Annoyingly, these tend to be the sorts of businesses that we most like to own; the ones that can reinvest at good rates of return and generate ever-growing earnings streams, albeit at the cost of short-term dividends.
The nature of discount rates is to more harshly penalise cash flows that occur further down the track. Because of this, companies that have modest earnings today but higher earnings down the track are more sensitive to the discount rate used for valuation, and stand to gain the most from any long-term discount rate decline.
Cochlear (ASX: COH) serves as a case in point. Cochlear has been a very rewarding experience for investors for many years, with a solid long-term record of earnings growth (albeit with some hiccups in recent years). However, if you do a valuation on Cochlear today, you need some quite punchy assumptions to get a result that matches the current market price. If we use a simple growth model that assumes COH maintains a constant ROE while reinvesting a fixed amount of new equity capital each year, the numbers might fall out as follows:
- Assumed ROE: 46 per cent – This is a big number, and it’s a little higher than COH has achieved on average historically, but we’re putting our ‘punchy’ hat on for this exercise.
- Assumed Reinvestment: $57m p.a. – This equates to COH paying 70 per cent of expected current year earnings as a dividend and reinvesting the rest. This, again, is a bit more capital than has historically been reinvested, but let’s go with it.
- Cost of equity: 8 per cent – At MIM, we are happy to vary the discount rate to reflect different levels of forecast risk, but 8 per cent is about as low as we like to go.
Based on consensus earnings of around $190m for the current year, these assumptions bring us to a share price of around $103/share. This is still well short of the current share price of $125/share, even with our ‘punchy’ hat on.
Valuation is always an inexact science, but to my mind it’s hard to make a case for faster growth or stronger economics than we built into those assumptions. However, most of the value in this example is in earnings that will accrue many years down the track, and the thing that can quickly perk up a valuation like this is a change to our cost of equity assumption.
In fact, a seemingly benign 100 basis point shift to a 7 per cent cost of equity completely closes that valuation gap.
So, value-driven investors who favour high quality businesses with long-term growth prospects are in a difficult situation today. They can go with the flow and use lower discount rates, or they can hold cash and wait for better value to emerge at some future point.
Holding cash feels painful. That’s probably a good sign that it is the right choice.