January 12, 2006

Thoughts on valuation approach for Banks

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.

1 comment:

Ashok said...

Good blog and good insights into value investing. Good to keep one's feet on the ground while the hype sweeps by.