Banking is probably the least understood sector in the stock market. In fact, the entire gamut of financial services makes for an interesting (if confusing) clutch of businesses that seems to be shrouded behind a veil of jargon and confusing numbers. At the same time, listed banks sometimes become the fastest money making machines in the stock market.
The conventional stock market wisdom of depending on price to earnings (P/E) ratios falls flat for banks. Why? Earnings per share (EPS) as a parameter does not fully capture the nuances of the banking business.
To pay a certain multiple of the EPS is to settle for a less-than-rigorous estimate of the true worth of a bank. This is because the reported earnings for a bank can fluctuate significantly from period to period simply on account of “adjustments” to its operating profit—the provisions for non-performing assets (NPAs) and taxes, both of which are not correlated to the operating profits of banks.
Analysts have relied upon two ratios—adjusted book value (ABV) and return on equity (RoE)—to help them zero in on the winners among banking stocks. Book value simply refers to the value per share after accounting for all accumulated profits and other reserves of the bank. This indicates the base value of shareholder’s wealth as contained in the account books of the bank.
This has to be adjusted for the “net NPAs” on the bank’s loan books, i.e. the portion of bad loans that is yet to be written off. What results is the net residual value of shareholders’ funds, on a per share basis. The fair price of each share of the bank should typically be a certain multiple of this. Assigning a higher fair multiple would lead to a high fair value. So what multiple does one use?
Typically, one would look at a long-term RoE as the dominant clue in this matter. If a bank is consistently earning a “higher than peer-set” return on shareholders funds, I’d be comfortable assigning a multiple of 3 (or even a little more) to its adjusted book value to give me the fair price of its shares. Also implicit in such assignations is the sustainable business growth rates for such a bank.
Many Indian banks (particularly the new private sector banks) grew their loan books at 25% and above in the past few years, resulting in strong accretion to shareholders’ funds (and therefore book value per share). At 2004 prices, they would now be quoting at around one-and-ahalf times their adjusted book values for today, making them look terribly cheap. No wonder they have appreciated by 100-200% over this period, pulling up their current P/ABV ratios to over 5 in some cases like HDFC Bank.
Led by visionary managements, banks like ICICI Bank, Kotak Bank and HDFC Bank have spread their activities beyond plain vanilla lending and have become multi-dimensional financial conglomerates straddling banking, insurance, mortgage lending, retail banking, wealth management, asset management, stock broking and even real estate.
These banks must necessarily be valued using a sum-of-the-parts (SOTP) approach wherein their holdings in subsidiaries and related businesses are valued in addition to the banking business. The largest bank in India (by book size)—State Bank of India (SBI)—owns a clutch of subsidiary banks and a fast-growing life insurance venture that must surely be valued separately if a fair value is to be assigned to the SBI stock.
Sometimes, factors other than pure financial brilliance come into prominence. For example, small private sector banks have become takeover targets especially when they have regional footprints that provide complementary market presence for a larger, more nationally oriented bank.
Good examples in this category would be Karnataka Bank (doubled over the last year on rumours of Reliance acquiring a stake in the bank), Lord Krishna Bank and Bank of Punjab (already taken over by Centurion), Federal Bank (fantastic footprint in southern India, particularly Kerala plus strong franchise with the expat Keralite community).
The darlings of the sector have been the aggressive “newcomers” among the private sector pack— ICICI Bank, HDFC Bank and UTI Bank (now Axis Bank)—while the heavyweights such as SBI, Punjab National Bank and Bank of Baroda continue to provide anchors for the sector.
The “revival” theme has been played out by investors in cases such as IDBI and later, more spectacularly, in Bank of India, Dena Bank and Indian Bank. “Sell-out frenzy” has driven up IFCI by over 400% this year, primarily on the back of the value of its investments. At Rs 63, IFCI is still one of the most actively traded stocks and there are fresh rumours of foreign suitors wanting to buy the beleaguered institution.
One more investing theme is the sector theme. Once in a while, you will find a lending institution focused on the specific needs of a particular sector. This player is uniquely positioned via its expertise, natural ability to lend to or appraise projects and become a lead lender in the sector.
Examples of such institutions: IDFC (infrastructure) and Power Finance Corporation (power). These companies command premium valuations because of the extra stability in their loan books and virtually assured growth, plus lack of regulatory constraints such as statutory liquidity ratio requirement.
However, the business of lending is inherently risky, and being a stakeholder in such a business is even more so. Particularly so when the recovery process for a sticky loan is governed weakly (loan recoveries in India can stretch into decades) and when the business of reporting performance numbers can be less than reliable (remember the large NPA mess that many public sector banks found themselves in a few years ago?).
Banks or institutions like IFCI, IDBI and UTI found themselves out of favour when the assets they had created turned sour, requiring government intervention and strong doses of good luck to salvage shareholder wealth in potentially messy situations.
Nobody gets fired for picking SBI in the portfolio, but as you can see, we have desisted from picking this India proxy in our SAFE WEALTH and WEALTH ZOOM portfolios.
Instead our choice rests on HDFC Bank and PFC as our bets for SAFE WEALTH, the relatively safer portfolio of the two. If you want to get a little more aggressive, try investing in IDBI (post merger, it’s a full-fledged bank with an amazing hidden value in its investment portfolio) and the high-pedigree management of Yes Bank, probably India’s most “capable” new bank on current form.
As usual, there are tomes of quantitative analysis to justify these choices. But I’ll spare these details for all of you except those who write in specifically asking for this stuff.
Dipen Sheth, Head of Research, Wealth Management Advisory Services