Daily Equity Report

All investors whether they know it or not are seeking a required rate of return. The only reason to invest into a company with volatile earnings and a volatile share price rather than a bank deposit is in the expectation of a higher rate of return.

Ultimately the success of otherwise of an investment into any asset has less to do with the outlook, earnings, economy etc, but rather the price paid relative to the intrinsic value. Overpay for an asset and no matter how fantastic the future outlook, the investment is likely to be poor. Conversely pay a cheap to realistic price for an asset and a few years of poor earnings and weak economy will do little to dampen the returns achieved.

On this note then let’s look at valuing cash flows and the required rate of return.

I spent the day yesterday listening to 5 local fund managers discuss their portfolios, how they have structured their asset allocation and the types of shares that they are investing in based on their investment process and outlook.

With most managers there was an element of getting more defensive.

One of the managers that we chatted to had however recently increased his exposure to equities following an undervalued position. Having done this on the basis that equity valuations reflected values that were historically cheap, he agreed that given some of the global structural changes, there was room to increase their required rate of return. His firm had in fact slightly upped their required hurdle rate 2 years back. The discount rate to value a listed company’s future earnings was in the ranges between 13% and 16%

I posed the same question again to a large fund manager today, asking them given what appears to be a slight structural change in the long run returns for asset classes, are they making changes to their assumptions used. Again the answer was yes, on cash the long run expected real rate of return may well come down to 1,5% while the required equity risk premium may well have to be moved up slightly from 7,5% to 8%.

Both fund managers had essentially updated the same assumptions to their valuations models.

What do I mean by discount rate and equity risk premium?

An investor with an array of options, in which to invest his capital, will want to consider the valuation of an asset using a required rate of return. The lower the perceived risk, the lower the required rate of return – the higher the perceived risk, the higher the required rate of return.

If one considers that listed equity should provide a 8% real rate of return instead of say 7,5% real rate of return over time, then when net present valuing future cash flows, an investor will slightly increase his discount rate.

Remember that the value of any business today is the net present value of its future cash flows. All investment managers try to make some assessment of future cash flows, discount these back to a net present value and then compare the result to the traded price.

At the basic level the formula for the discount rate is the risk free rate plus an equity market risk premium.

On the other hand as interest rates or the risk free rate declines, so the discount rate will decline, which is positive for valuations.

Despite the haziness of the future outlook, and even after applying higher discount rates, there are many assets that appear attractively priced. From this reduced starting point and taking a reasonable investment horizon, investors should be adequately rewarded for the risks taken.

Kind regards

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966