This is my first blog post in a series of posts where I value companies from the top down and explain my story for the numbers I have used and the process I go through. I use different versions of the discounted cash flow model to value companies. Through this post I intend to value RBL Bank. FYI If this approach seems familiar it’s because I have learnt IT by following Aswath Damodaran, Professor of Finance at the Stern School of Business. Also, since I am an Indian, live in India and have access to invest in Indian companies most of my valuations will be of Indian companies.
RBL Bank: Business
Banking is a remarkably opaque business and yet it is the business most misunderstood. At its heart the business of banks is accepting money in deposits, dispersing loans and profiting from the resulting difference of interest. RBL Bank is one of the fastest growing private banks in India. It is one of the banks which have invested heavily in financial technology which is evidenced by the fact that it has seen 4 times growth in digitally acquired savings account and is one of the top players in terms of Aadhaar enabled payment systems. The loans have grown at a very quick pace and it has a decent net interest margin of more than 4%. Its return on equity has been low primarily because of the high contingency provisioning requirement. The Non Performing Assets which have hurt almost all banks haven’t spared RBL Bank.
Why I decided to value RBL?
I took more than 20 public and private Indian banks and ran a regression for the price to book value against Return on equity, tier 1 ratios and capital adequacy ratios. I got an R squared of 77% which basically means these three variables explained the price to book ratio 77% of the times which is quite big for any data set. I then tested the regressed value of price to book against the original value and found that RBL was under priced by the market. This basically made me curious and I decided to value the company. The regression is displayed for reference.
RBL Valuation: Story to define the numbers
RBL Bank is still a relatively small bank. It is in the 20th percentile of all Indian banks by Market Cap. The bank is growing a breakneck speed and is set up to go digital. The gross and net NPAs are at 3.65% and 2.05% respectively. The return on equity is low at just below 5% but that’s primarily because of provisions for non-performing assets. The net interest margin at above 4% suggests that the bank has relatively low cost of funds. In my story I have assumed that the bank continues to grow its advances by 11% which gives me a total advances by the year 15 of just less than 3 lakh crore which is about 75th percentile for banks as of now. The rate is low because the bank may face problems in the future due to corona virus and the increase in NPAs. Its unsecured loans percentage is around 48% which is very high. For reference this number for ICICI, Axis and HDFC Banks lies in the region of 27–30%. For quite a few banks it is even lower. To counter this I have added the following assumptions in my story:
· High Beta: My starting beta is extremely high at 1.85. This encapsulates the high risk of investing in this stock. Using the CAPM this gives me a starting cost of equity of 19.42%. As I go on and the company matures the cost of equity drops down to 12.52% by the end of the 15th year
· Low Return on Equity Numbers: In the first 5 years I expect trouble with rising NPAs and increase in provisioning requirements and hence have computed a low return on equity of 3%. I expect things to improve post that with an ROE of 9.5% in years 5 to 10 and 12.52% in years from 11 till the terminal year. Finally I assume that by the terminal year the company will earn its cost of capital
· Probability of an Equity Wipe-out: I recognize that even after adjusting for risk the company can simply fail and have factored in 15% probability of an equity wipe out
· Reinvestment: While for most firms book value is an outdated figure it is not so financial firms because they mark to market. The regulatory capital ratios are based on book equity. Thus a bank with negative or low book equity will be shut down by regulators. RBL has a decent capital adequacy ratio at 15.6% and I have assumed that will keep growing for the next 15 years. From a valuation perspective I have assumed that reinvestment for a bank is the amount it needs to add to book equity to sustain its growth ambitions and safety requirements.
· Terminal Year: In the terminal year I assume that the bank grows at the risk free rate at the return on equity equal to the cost of equity
I used the discounted cashflow model to arrive at the value of equity, added back the cash and subtracted the outstanding options which amounted to 100.23 crores. I used the black scholes options pricing model price the options. The sheet is displayed for reference. After factoring in probability of an equity wipe out I got a value per share of INR 209. The price at the time was INR 181.
Monte Carlo Simulation
This isn’t a buy recommendation on the stock. I recognize that there are a lot of assumptions which can take different values. I used a probability distribution for the parts which I was least confident about which were the ROEs for the years 1 to 15 and the probability of an equity wipe-out. Subsequently I ran a simulation 10 lakh times to arrive at the following:
This simulation indicates that there is a 93% chance that the stock is undervalued. More importantly it captures the tail as the distribution is skewed to the right.