“What do you see, son”? Asked Guru Dronacharya. “Only the bird’s eye, Sir”, replied Arjun.
-the Mahabharat
We all have grown up listening to this Mahabharat story on importance of focus. Whether its archery or investing, great achievements demand undivided focus. The bird’s eye equivalent in long term investing that demands undivided focus is company’s intrinsic value (or economic worth, in simpler terms). For, only that can help us decide if a company is undervalued or overvalued versus its stock price. Everything else, is noise.
To recall, a company’s intrinsic value is the present value of its future free cash flows. Two broad components of intrinsic value calculation are (1) future free cash flows (i.e. cash earnings less investments) and (2) future interest rates to discount those cashflows to their present values (aka discount rates).
Assessing intrinsic value, thus, requires looking into the future – for both cash flows and discount rates. Unlike Arjun’s bird in the Mahabharat that is still and clearly visible, intrinsic value is therefore a moving and hazy bird.
Future cashflows: Either due to their nature or our current ignorance, we cannot imagine future cash flows of most of the companies. It’s futile to even attempt their intrinsic value calculations. For, in archery parlance, we cannot even see the bird. Nonetheless, there is a sub set of companies where we can. Mostly these companies provide essential, under-penetrated or non-substitutable products/ services competitively and are run by able and honest management. They are expected to see reasonable revenue growth and high returns on capital. Here is where we limit ourselves looking.
Future interest rates: For intrinsic value purposes we are concerned, not with interest rates of next quarter or year, but with long term future interest rates. Just as assuming very low long term future interest rates is mistaken (last 10 years), so is assuming very high long term interest rates (temptation today). We need to assume moderate interest rates over long term in our intrinsic value assessment. Given that 30-yr Indian government securities are yielding around 7% today (2024), 4% is too low, and 15% too high for discount rate. Anywhere between 10%-12% sounds okay, today.
We need to place all incoming information in above backdrop. Discipline to limit ourselves to sound companies and focus on their intrinsic values that correctly embeds future cashflows and long term future interest rates will allow us to ignore noise and take right investment actions.