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Understanding valuations of banking and finance stocks

They use money as their raw material, thrive on high leverage and are evaluated on very different metrics from manufacturing companies. As an investor, your approach to analysing and choosing banking and finance stocks needs to be distinct too. In the first part of this article, I had dwelt on the CAMEL approach to deep-diving into a bank’s business.

But the CAMEL approach does not tell us about the valuations at which the stock trades. But the starting point, for me, is to get the first part away, to see whether I can trust the reported book value of a finance company or bank. The CAMEL helps me determine this. In early companies or new entities, the “M” becomes a key determinant. If the “M” is high quality, the rest of the CAMEL should logically follow.

Banking and finance stocks, Understanding valuations of Banking & Finance Stocks

Banks versus MFs

For simplicity’s sake, it is possible to compare the business of a lender, at one level, with a mutual fund structure. A pool of money (capital plus debt) is invested into assets (which are loans in the case of a bank or NBFC) to earn a return. From that income, the costs are reduced, the bad loans and provisions for doubtful loans are also reduced and the balance is attributable to debt providers as interest and capital providers as profits. 

Lenders tend to be evaluated mainly on the rate of growth in their loan books. India is an underbanked country and there are many pockets where there has been low penetration. Thus, this is one big differentiator with a mutual fund. In a mutual fund, it is NAV and nothing beyond. We do not give it a premium or discount based on expected future share prices of what it holds. In a bank or finance company, we are paying for the future size and quality of the assets and how they evolve.

The ROE Test

This is indeed why we find that shares of banks and finance companies trade at varying multiples of their reported Book Value (which is akin to a mutual fund’s NAV).  There is less focus on price-earnings multiple or PE with such stocks. One interesting thing is that the transparency in the business results in a ROE that is typically lower than the manufacturing and services businesses. We can see a Hindustan Unilever with over 50% ROE, but it is a rarity to see a bank with even 20% ROE. Thus, as a business choice, it seems to me that banking or finance is not inherently a great space to be in. However, what drives promoters to still crave banking licenses is the growth possibilities and increasing returns on invested capital.

Strength in a niche

Before getting to valuing a bank or financial company, I would like to satisfy myself that the CAMEL passes scrutiny and that the ROE is sufficiently attractive. I also want the lender to be present in a space that is growing. Being an underbanked nation, everyone will say they have a niche or some USP and it is up to us to figure out whether it is really so. There are many examples of lenders who have created and built specialized credit skills that have made them wealth creators in the market in the long run. 

For example, Bajaj Finance has a dominant market share in financing consumer appliances. Their speed, their technology and their size give them an advantage that is not easy to conquer. The management quality is also very favourable in terms of trust. They enjoy a great ROE. Similarly, Sundaram Finance has built its core competencies in the vehicle financing segment. Their management of risk across businesses is outstanding. Cholamandalam has demonstrated its strength in vehicle finance and is now making headway in Home Loans and MSME lending. Muthoot/ Manappuram have their dominant market positions in gold loans. Similarly, there are micro finance companies that have done well in their chosen niche. 

There’s a perception in the market that a banking license is some sort of Holy Grail that guarantees special privileges. NBFCs are often asked why they aren’t throwing their hats into the ring for banking licences. To me, that is a transition which dilutes their existing strength. A non-bank has several advantages that banks do not have. They can focus on niches without trying their hand at ‘universal’ banking and can build strong connections with their borrowers, which helps in credit appraisal.

Stock selection

So to produce a checklist – In selecting lending stocks, I first look at who owns and manages the company. Then, I evaluate who is their customer segment and what is its growth potential. This must be balanced against its riskiness. Then, I look at the ROE the business generates. Once you like a company on these three points, then it makes sense to make a buy decision. Yes, beyond this, there are some other things like ‘value of a subsidiary’ or an associate company. For example, a Kotak Bank or a HDFC Ltd own other businesses which are worth more than the original cost of business attached to them. This has also to be factored in. And this is one reason why they seem to command very high valuations in relation to other vanilla lending companies.

Assessing valuation

Once I shortlist lending companies I like based on the above metrics, only then do I evaluate their Price to Book Value. I prefer to buy when the Price to Book Value is closer to the lower end of historical highs/lows. I have attached a table of Cholamandalam Finance as an example. I am NOT recommending the share. 

This how Cholamandalam Investment and Finance’s Price to Book ratio behaved in the last few years:

We see that there are buying opportunities when the P/BV falls below 3. At near five times, there is not much room for further upside. In 2020, the shares across the board collapsed. Clearly, when the company’s P/BV fell to 1.5 or even below 2, it was a juicy opportunity. Unless we think that there are fundamental changes for better or worse, this discipline of having a system to follow, will help us make better buying/selling decisions with respect to banking and NBFC stocks.  

To me, a low P/BV is in itself not a reason to buy a bank or NBFC stock. We do not buy a PSU bank simply because its P/BV is 1 or below 1, when a private bank is selling at say 4 times book value. There is a reason to suspect asset quality and growth combined with poor ROE, which is why some banks command a low multiple. However, when you see ROE expanding and growth happening in a PSU bank, there could be a re-rating. Speculative news about ‘privatisation’ itself has been sufficient to re-rate the stocks of many PSU banks. This drives home the point that if there’s a single valuation and price driver for banking and finance stocks, it is the M in the CAMEL.

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