“Price is what you pay and value is what you get” – Warren Buffett.
It is a profound and straightforward statement, but only if the intrinsic value could be so easily determined!
The Financial world is a great symphony, in which multiple asset classes interact to create a harmonious tune of wealth generation and risk diversification. Each asset class, whether equity, debt or real estate, has a distinct function to perform in this elaborate orchestra of financial assets. Like the various instruments that make up a magnificent symphony, these asset classes too have specific characteristics that affect their value.
We often get questions around the valuation of markets from our clients and partners; hence in this letter we have attempted to decipher the following:
Factors that drive intrinsic values and valuations across asset classes
How sensitive these factors are to variation in intrinsic values
Are Indian Equities expensive?
Valuation of “any asset class” is an interplay of only the following four factors:
a) Return/Income – The return/income that asset generates
b) Growth – The underlying growth
c) Discounting Factor which in turn is total of
Risk free rate of interest
Risk premium – extra returns that the investor would require to compensate for the risk taken.
d) Term/Tenor
All the above eventually contribute to intrinsic value, but it is also crucial to note that the more uncertain and dynamic the variables, the more intrinsic values are susceptible to the variables/assumptions used. Government securities have the fewest dynamic variables, while equity has the most.
Since we now understand the components that drive intrinsic values at different periods in time, let us consider how sensitive these factors are which results in large variances in the intrinsic values with changes in these factors' assumptions.
Government Securities:
When investing in GSEC debt instruments, one is assured of the coupon rate that he will receive till maturity. Furthermore, because it is sovereign debt, there is no risk of receipt of coupon/principal. However, with the change in interest rates, the GSEC’ issued earlier, trade at a discount/premium depending on the differential in coupon and risk-free rate at that time. A 1% drop-in interest rate in GSEC with a duration of 6, will lead to ~6% appreciation in the Bond Value.
Corporate Bonds:
When the identical debt instrument is a corporate bond, the coupon rate is fixed, but there is risk associated with the corporate's solvency, resulting in a risk premium required over and above the risk-free rate. The risk-free rate or risk premium could change, causing the fair value to change.
In the table below, with an 8% coupon rate and a 9% discount rate, the intrinsic value is 96/-, but we can see how the intrinsic value changes depending on the discount rate, which is a combination of the risk-free rate and risk premium. While the risk-free rate can change depending on economic cycle, fiscal/monetary policy, etc the risk premiums can vary depending on a variety of factors specific to that company.