How do you value a growth stock like Cochlear?
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.
Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. To invest with Montgomery domestically and globally, find out more.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Jason Horne
:
Hi Tim,
I regular see companies like Cochlear have a market value well above their intrinsic value and they seem to have “lived” there forever, even through the GFC. But consistently shows reasonable growth even though it above the intrinsic value. Does this reflect:
1. The market getting it “wrong”?
2. The intrinsic value modelling is missing something.
3. Would you consider this to be a risky investment?
Please excuse me if the answers here are obvious. I am not a expert. I expect the answer are not black and white, as shown in the blog.
Regards
Jason
Tim Kelley
:
Actually Jason, none of those questions are easy to answer definitively.
1. We find it hard to see value in Cochlear, but even if we’re right, if it stays expensive forever then value is not a very successful stock selection tool in this instance. The market can not be said to be “wrong” if that is the case.
2. We are reluctant to lower our long-term return hurdles in response to low interest rates, and that leads us to estimate lower valuations that we otherwise would. Some would say we should be less reluctant.
3. The underlying earnings for COH are relatively robust, but to our way of thinking there is considerable risk in buying shares at too high a price. The answer to Q3 therefore rests on the how you feel about Q2.
Jason Horne
:
Thanks Tim.
I agree, with point 2, why change a proven model to suit the stock, or market in general. The market is fickle.
Mark Walmsley
:
Hi Tim,
Is there anywhere where your guys have shared insights into your industrial DCF model? I’ve read Roger’s book and understand how to value using the methods contained therein but am looking to understand the next level of detail.
Cheers and thanks,
Mark
Tim Kelley
:
I’m afraid not, Mark. I’d encourage any keen investor to learn how to build a DCF, but it’s a big topic; one that is a bit beyond the scope of the blog.
rob barnett
:
Tim,
Assuming a beta of 1 you have computed an equity risk premium of around 6 in your cost of equity which by historical standards is quite high (although I note that some analysts quote a beta for COH of 0.5 which would potentially imply an ERP of 12 in your back of the envelope example). What is the “house” view on where the equity risk premium currently sits? Do you rely on historical measures or do you use a more dynamic, forward-looking approach to this estimate?
Many thanks & best regards, Rob
Tim Kelley
:
Hi Rob. We’re skeptical about CAPM at the best of times. In a world where the ‘risk free’ rate is distorted by central bank policies we’re especially skeptical, so we can’t easily comment in terms of ERP and Rf. We’re more concerned with value risk than price risk (noting that the two can be quite different), so we think about discount rates more in terms of the risk of earnings falling short of our projections. This is fairly insensitive to central bank policy and overall market risk aversion.
bex taiwan
:
Hey Tim, do you ever find a time when you would want to deviate from a simple model such as above?
Tim Kelley
:
Yes. Every investment decision we make tends to have an industrial grade DCF behind it. The method used here is a good way to quickly understand the key valuation drivers, but DCF is more powerful.
Wayne Bartley
:
Hi Tim
Agree Cochlear’s price is looking a little stretched, to say the least
Also agree in not changing your cost of equity to justify the shareprice
I believe in doing so, would be encroaching into your margin-of-safety