“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.
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.
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.
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.
In recent times, we have witnessed several cases of uncertainty at Vedanta, Adani Group, etc. when the yield to maturity shoots up due to an increase in the risk premium as the perceived risk of market towards that company changed.
Sensitivity for discount rate
Commercial Real Estate:
In the case of commercial real estate, the source of income is rental income (subject to vacancy) which net of expenses results in net operating income relating to that asset. The most essential variables here are rental yield, escalation in the rental, lease tenor and discount rate, which determines the asset's fair value; all other factors remain constant across asset classes.
Incremental/sustainable growth of rental income is also a key variable however, given the real estate contracts are usually long term and have an escalation clause, these are relatively easier to predict and capture in the intrinsic value calculations.
Thus, the major fluctuation in intrinsic value occurs due to discount rate (risk free rate and risk premium).
Now comes our favourite topic, Equities - as an asset class, has the most dynamic variables among the asset classes discussed above, and they all have an impact on their valuations. What makes it complex is the differing degree of assumptions and expectations about each of the four variables.
The returns (Profits or ROE) a firm will generate. Higher the ROE, better the valuation.
Growth, a firm will have over long period. Perpetual nature of equity makes it more complex, as one is supposed to make assumption for medium term and perpetual/terminal growth. Higher & more predictable growth will command higher valuation and vice a versa. That is why commodities command lower valuation than consumer companies.
Cost of capital plays an equally important role in determining the intrinsic value that the company will have at various points in time. Again, the risk premium would differ depending on the quality of business, quality of management. That is what leads to a wide variation in the valuation market assigns to different sectors and within sector, different companies.
In the example below, we have assumed that a company generating income of 15 and 3% growth in perpetuity with a 12% discount rate, would be fair valued of 225/-. Running sensitivity on various assumptions gives us a good understanding of how the company's intrinsic value can deviate.
Sensitivity w.r.t income and Discount rate:
As can be inferred from above, with a 9% discount rate and same income of 15, the fair value is 393/-, and with discount rate of 12% but income of 12, the fair value is 180/-.
Sensitivity w.r.t perpetual growth rate and discount rate:
The range of fair values also differ a lot with the highest being ~353 and the lowest being ~86.
The above sensitivities would be more for equities vs real estate as the uncertainty and complexity in variables is higher in equities.
Perception around these variables is what drives the asset prices all the time
We have seen how these factors impact intrinsic values and valuations. But how do these eventually play out in the real markets??
More than actual variables – the perception of these variables play a key role in the valuation of these assets. While the interest rate variables affect the risk-free rate perception of market, the slowdown variables affect the growth perception. Whether or not there is an actual slowdown - the market perception and assumptions in place for different assets classes drive the valuation among these asset classes.
For e.g., during covid times interest rates were falling and so were the valuations/intrinsic values because expected growth was low and risk premium was very high.
So, if you must take a view on the valuation, you must take a view on each of these factors i.e., ROE, Growth, Risk Free Rates and Risk Premium.
Here are some interesting facts:
Everything else being the same, with a 2% drop-in the interest rate/risk premium, equity value increases by ~40%
Everything else being the same, with a 2% increase in terminal growth, equity value increases by ~31%
Everything else being the same, with a 2% improvement in ROE, equity valuation increases by ~13%
(Of course, this is subject to some assumptions, there can be thousands of assumptions for interplay of factors)
Let us share our view on each of these factors in the current context:
ROE – India’ ROE profile has been better than most emerging markets for a long time. This itself is a significant starting point why it has traded at a premium historically. We see this either staying at current levels or marginally getting better.
Growth – Growth perception and expectation keeps varying from time to time. During Covid times, it looked bleak. Today it is looking very positive. There cannot be a denial, that perception about India’s economic growth and corporate earnings growth is far better. As is seen in the chart below, corporate earnings to GDP ratio of ~4.1% is still in the middle of the cycle. Perception of India’s growth sustainability on a relative basis to all EMs (China, Brazil, Russia, etc) is far better. This surely calls for a higher premium to them than in the past.
Risk Free Rates – India’s interest rates compared to the rate cycle globally is one the lowest ever. The Spread between the US 10 year and 10-year GSEC is at 3.16% and difference between inflation is also the lowest. We have outlined our view in the previous letter that interest rates have peaked out.
Risk Premium – A country’s valuation is determined by the risk premium which is a function of how stable, sustainable the economic growth is. There can be no doubt with series of reforms being carried out in the recent past and along with balancing the economy with deep focus on manufacturing & infrastructure development, India’s and Indian Equities Risk premium is steadily reducing. At the same time, it has gone up for China thereby impacting valuation negatively.
Our view has been, if each of these factors (ROE, Growth, Interest Rates, Risk Premium) are far better than any time in the past and better than any other markets, why should people question & worry about India’s premium valuation compared to the past and other EMs.
We are not questioning and worried! Despite the above, if India were to trade cheap, one should worry. People who continue to believe in the narrative of current markets being expensive, may end up missing a big growth and wealth creation opportunity. We are not making a point that there are no risks or there won’t be any volatility in the markets. There will be. We are making a point that we do not find the Indian markets expensive. Surely there are pockets of euphoria, which one should avoid, but not the markets.
The melody of asset valuation is never static, but rather a dynamic composition. Just like a conductor creates harmony in a symphony, we must grasp the various dynamics to make the right decisions in the ever-evolving financial landscape. Further, given money is fungible between asset classes, the market perception and assumptions lead to points of exuberance and trepidation in asset valuations.