nice analysis. But I get some thoughts here.
1. What if the bank had been increasing leverage to increase or maintain higher ROE? The bank wud have maintained a 20% ROE, but leverage wud have gone higher and hence the risks. Would you not like to consider higher ROE maintained at stable net interest margins and stable net profit margins in your equation? Paying higher price to book just to maintain higher ROE can be a double edged sword where leverage can be dangerous. Dont we need to maintain our profitability and margin spread too?
2. What would you pay for a bank/nbfc with a low leverage (Say IDFC with leverage of around 4 times)..that has potential to increase leverage and hence ROE in future...as per your ROE equation, IDFC wud get a low Price to book.
3. Why shouldnt we consider ROA (assets net of NPA) instead of ROE in ur calculation? THis will show if constantly increased leverage was the reason in maintaining ROE or not.
I agree with all the above points. The post on bank valuation is a simplistic approach to valuing a bank. I always consider leverage an important variable expecially for a financial institution, such as a bank. As a matter of fact I tend to avoid companies with high leverage unless they are well run. Businesses with high leverage are extremely dependent on the quality of management. A small error by management can hurt the business very badly (note the number of banks and FI which have failed and been bailed out by the government on tax payers money).
What I should have put in my previous post is that all of the following factors being in favour, ROE can be used as a good variable to value a bank.
1. Leverage – This is represented by CAR (capital adequacy ratio). Higher the CAR, better the quality of the business. As a personal note, I prefer to select banks with CAR of atleast 10-12%
2. Level of NPA and asset quality. A bank can have high ROE and still have a lot of problems loans which are hidden by a practise called as greening of loans (give loan to an existing account to prevent the loan from defaulting)
3. Level of operating expense / Net interest income. This reflects the operating efficiency of the bank
4. Level of non-interest, fee based income. Higher the better.
5. Brand name, retail network and management quality. All fuzzy factors, but fairly important ones for a bank
I tend not to overwiegh ROA. An ROA of 1.3% or more is good. Acutally a very high ROA may not be a good sign (possible that the bank is lending to high yield, high risk segment)
I also agree with prem’s point that if a bank has a low leverage, then earnings can expand more easily. To put it another way, the bank will have no need to access the capital market to raise equity to fund its growth (one of the problems being faced by several public sector banks).
All said, valuing and analysing a bank is far more diffcult (according to me) than other businesses. However the ROE approach can be taken as one approach to arrive at an estimate of intrinsic value. I acutally use this instrinsic value as a starting point and then adjust this number based on the other factors, after the bank meets the basic quality standards