There are few stocks today trading within our calculated intrinsic value spectrum for 2018. Similarly, you don’t have to look too far to find high quality stocks that seems to have overshot their intrinsic value. As value –driven investors we have two choices: use lower discount rate to justify investing in these stocks, or hold our cash and wait for better value to emerge.

We recently talked about how cut in the interest rates drive valuations to rise of any assets. These valuations shoot up because investors opt lower discount rate while calculating intrinsic value. But in the stock market, this does not happen with all the companies consistently. The companies most affected are those that have excellent prospects for long-term earnings growth.

Annoyingly, these tend to be the sort of businesses that we most like to own; the one that can reinvest at good rates of return and generate ever- growing earnings stream, albeit at the cost of low short term dividends.

The discount rate plays crucial role in it. The 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.

Eicher Motor is one of the example that displays same characteristics. If you had invested in this business from past 5 years, you might be sitting on handsome returns earned from this stock. Yet, if you do valuations of Eicher Motor today, you need some quite punchy assumptions to get a result that matches the current market price.

Let us do a bit of maths here and look at how valuations play out for Eicher Motor:

Assumed ROE: Eicher Motor reported its 2016 ROE of 43%. This is high number and will be really tough for Eicher Motor to maintain in the future years. But as we are wearing ‘punchy’ hat for this exercise, let us assume its ROE to be 43%.

Assumed re-investment: Rs 2,170 crore p.a. – Eicher Motor pays 20% of its earnings as dividends and re-invest remaining back in to the business. Eicher Motors had reinvested Rs 1,022 back in the business in 2016, so definitely the assumption figure looks too high for 2018. But let’s go with it.

Cost of Equity: Many investors ask this question, what is the best discount rate to apply in India? Tough question, because we do not use uniform discount rate on all the companies. Let me explain this concept with what the least discount rate we apply to Australian equities, which is 8%. In Australia long term inflation is sitting at 2%, risk free rate at 1.5% (Bank deposit rate). In India, Long term inflation is sitting at 6.75%, risk free rate at 6.25%. So definitely cost of equity can’t be as low as 8%. Let us take for this example cost of equity as 13%.

Based on consensus highest earnings forecast for 2018 to be Rs 2,540 crore, these assumptions bring us to share price of Rs 24,157 per share. This is still short of market price today trading at Rs 26,300 per share, even with our ‘punchy’ hat on.

Valuation is always is an inexact science, but to my mind it is 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 its 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 its cost of equity assumptions.

If we drop our cost of equity assumption to 12% then the Eicher Motors upper band of intrinsic value changes to Rs 28,196 per share and that gap is gone. More to it, it starts looking cheap by almost Rs 2,000 per share.

So, value – driven investors who favour high quality businesses with long term growth prospects are in difficult situation today. They can go with the flow and use lower discount rate, 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. So we are going with that. What are you doing?

Aziz Dodhiya is the chief investment officer for the Valueoperations funds which operates in the Indian market as an FPI (Foreign Portfolio Investor). We do not offer any personal advice to buy or sell any stocks and the views that are shared by Aziz might not incline to your personal investment strategy and this is the reason we advise you to take professional advice before going ahead with our views.