I have been reading shankar’s blog and left a few comments on his post about valuing a financial institution (like a bank or FI etc).

Shankar left me the following comment

Rohit, help me in arriving at a sustainable valuation model for banking sector. Debt recap / NCA will not work here. I can only think of P/E ratios but then this works on the whims and fancies of interest rates. Any guesses?

Its always easier to figure out what does not work v/s what does. That said, I have tried to come up with a valuation approach for banks and such lending institutions.

So here goes –

To start with let me try to list the reasons why valuing a bank is different from any other business

• Role of cash: Cash for a bank is equivalent to raw material and is used for creating the Product – Loan / mortage etc. For other businesses, cash serves as a lubricant (for lack of better word) to run the business. Hence for most businesses, cash is held for liquidity purposes. For banks, cash or equivalents is held as a raw material itself.
• Free cash flow: Free cash flow (after considering Capex) can be calculated easily for most businesses. Difficult to do for banks as their assets are not really the building / equipment etc. Assets are mainly the loans/mortages/ investment made out of cash. A business in absence of opportunities can return the cash to the shareholder. For a bank, the amount of free cash is not dependent on the opportunities itself. A bank has to maintain certain liquidity based on statutory requirements such as the risk profile of the assets.
• Role of book value: for most businesses, book value is an indicator of money invested. But may not be a big indicator of the instrinsic value. For banks, book value (net of impaired assets) is much more important indicator of intrinsic value
• Risk: Bank by their nature are risky businesses (I have read comments by buffett / munger to that effect). Any business which has a leverage of 10:1 (which banks do), can fall apart quickly due to mangerial mis-steps

My typical approach (which in my opionion is not sufficient) to value banks has been

• P/B ratio – I try to look at the relative valuation through this ratio. A high quality bank (in terms of operational efficiency, NPA etc like HDFC bank) would sell at higher P/B ratio. It is important to figure out the correct book value (preferably book value net of impaired assets)
• Long term return on equity – Higher the better, provided the bank is not making risky loans
• % of Net interest income to total income – Would want fee based income to be a higher proportion of the total income. Fee based income is typically less volatile and has low risk.
• Operational efficency – higher the better
• Presence of competitive advantage through – Distribution network, brand and quality of management etc which will allow the bank to earn higher than average ROE without undue risk

So effectively I do not have a quantitative (discounted cash flow type) approach to value banks. However I have tried to use a relative valuation approach. At the same time, according to me banks are risky businesses. One can never be sure what is the risk in the loan portfolio / derivative portfolio of a bank (you just have to trust the management). As a result I try to look for a higher margin of safety. I typically try to buy only when the bank seems to selling between 1-2 times book value provided the bank is looking good on the other factors.

Please share your approach/thoughts on valuing a bank. It would help me/others in developing a better approach to valuing a bank or any other financial institution.

Found an interesting view on indian economy from the ‘Morgan stanley GEF’ website

Some interesting observation in the article

We believe that a large part of the recent growth in industrial production and to a lesser extent services sector growth has been driven by cyclical global factors. A sharp fall in real interest rates since 2000 has encouraged both the government and households to borrow aggressively.

And

Acceleration in consumption growth has largely been driven by a rise in borrowing rather than income growth. Strong domestic consumption has been one of the key factors pushing the combined growth of industry and services sectors, which has averaged 9.3% over the past four quarters.

Second, rapid growth in leverage is also resulting in more credit risk in the financial system. Our banks team sees a rising credit risk building in the system as Indian households have leveraged significantly above the fair level that is supported by the current trend in per capital income. The central bank also relayed similar concerns.

The above makes you think about the valuation of banks which are showing strong profits and very low NPA. For Ex: ICICI bank has brought down NPA from 4%+ to below 1%. What are the kind of risks these banks have on their balance sheet due to their aggressive retail loans ? Somehow retail loans are now seen as low risk, high return and high growth area for most of the banks. As a result there has been a substantial growth of the retail portfolio. Maybe the overall risks are low (atleast the market has priced the bank stocks accordingly). The problem with bank loans is that these problems can remain hidden for a long time. As buffett as ‘Its only when the tide goes out, that you realise who has been swimming naked’