I have been reading the book – The warren buffett way (previous post here). There are several instances of valuations in the book on various companies such as Cap cities/ABC, American express etc. One point which caught my attention was the comparison of a company to a Long term bond investment. Buffett has mentioned several times that he uses the long term bond rates for discount in the DCF model.

Using the above comment, I have used the following thought process to look at another way of valuing a bank (earlier post on the same topic here).

The current long term rate for a 10 year bond is say 7 % (example purpose). So I would be ready to pay 100 Rs for this bond (face value). Now if I have a bond, say Bond B (of similar risk) which pays 14 % on face value, I would be ready to pay around Rs 188 for a face value of Rs 100 for the Bond B (A 7% bond would give 196 Rs in 10 years v/s 370 Rs for the 14 % Bond).

Taking the analogy to equity, lets consider a bank which has an ROE of 14%. Assume a 10 year period for which the bank can maintain this ROE ( This is the crucial part as this is the assestment an investor has to make on the competitive advantage of the Bank and its ability to maintain the high ROE). Beyond the 10 year period the bank’s ROE returns to 7% and so the bank in investment profile is similar to a Long bond.

In the above case, the Bank is similar in its return profile to Bond B. So everything else being equal I would value this bank at 1.88 times Book value.

Ofcourse the above is a very simple sceanrio. But we can add more complexity to the above case and make it more realisitic

Case 1: The ROE is 20 %. This ROE can be maintained for 10 years as in the above example. In such as case, I would value the bank at 3.14 times book value.

Case 2 : The ROE is 14%, but the Excess returns can be maintained for 20 years instead of 10. In such as case the valuation can be at 3.55 times book value

Case 3 : ROE is 20% and the period is 20 years. In that case the bank can be valued at 9.9 times book value.

So the simple conclusion is that higher the ROE and the longer the period for which it can be maintained, the higher is the instrinsic value of the bank (which is basic Discounted flow approach).

The above is a more shorthand approach of valuing a bank. I would look at the valuation in the following way now,

– What is the ROE for the bank
– What is the adjusted book value (net of NPA)
– What is the likely duration of excess return (select only a bank which is well run and hence the duration is atleast 10 years)

Based on the above factors I would prefer to invest at 1.5 – 2 times the adjusted book value (keeping a reasonable margin of safety).

2 Comments

  1. Prem Sagar says:

    Hi Rohit,
    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.

  2. Prem Sagar says:

    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.

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