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The objective is to give a range of fair values to Bandhan Bank’s IPO to help the reader make an informed decision before investing (and the idea is certainly not to predict listing/short-term gains). Relative valuation alone does not really help us when the firm does not have a close second.  In our daily life, we like to pay for and invest in tangible things that are priced at fair value, right? And hence the same thing holds true for stocks. In this article, I have tried not to repeat the details about this IPO that are all over the internet. Of course, I have used a lot of data from their Red Herring Prospectus (RHP) and attempted to use some of that key data in making assumptions for the valuation.

I have used the straight forward Excess Return Model (as opposed to FCF methods – reasons presented in the absolute valuation section) to value the stock of this Financial Services firm BFSL. This method is simple yet very robust for stock valuation Financial Services firms, especially when operational history is limited.

The stock is available at an upper band issue price of Rs. 375.  The issue is overpriced if we assume that the past ROE of 25.55% would be achieved consistently in the future.  However, on using excel goal seek functionality which forces the issue price to 375 per share, we arrive at an ROE of 33.80% i.e. if the bank experiences a consistent ROE of 33.80% in the future, it would make the issue fully priced

The below sections shed light on the some of the important qualitative and quantitative factors and then I go on to use those factors in arriving at a range of fair values. You might want to skim straight to the last section on absolute valuation.

The Business model of the entity has transitioned over the years, operating as an NGO in 2001 and then a non-bank finance company (NBFC) before becoming a bank (operations started in Aug 2015), the provision of micro loans to woman has remained a core focus

Competitive advantage –

• Bandhan Financial Services Limited (BFSL) reaches micro loan customers largely through an extensive network of low cost doorstep service centers (DSC). Low-cost model is demonstrated by our operating cost-to- income ratio was 35.38%
• The Bank boasts of a differentiated model since on one end they have a stable source of low-cost funding through Current Account and Savings Account (CASA) deposits, which forms 33.22% of their total deposits. On the other end, ~90% of their lending is to microfinance customers which earns them relatively high yields of 18.40% (as of December, 2017)
• Focus on underbanked and underpenetrated markets allows to meet certain regulatory requirements
• RBI requires that
  1. Banks locate at least 25% of their banking outlets in what it calls “unbanked rural” areas. Bandhan Bank has 29.15% of their banking outlets located in unbanked rural areas
  2. Minimum 40% of all lending to be made to Priority Sectors, which includes micro loans. Bandhan has 96.49% of their Gross Advances as Priority Sector Lending (PSL) compliant as of December 31, 2017
• As per the RHP, “while traditional established commercial banks may not be well suited to targeting unbanked rural areas or providing PSL-compliant lending, and thus see a drag on their profitability and yields. Rather, Bandhan Bank targets unbanked rural area segments by choice, operating a low-cost network designed to cost-effectively and profitably reach these segments”
• According to CRISIL Research, Eastern and Northeastern India, which are Bandhan’s strongest markets, have the lowest presence of bank branches per capita of any regions in India
• As of December 31, 2017, percentage of Gross NPAs to Gross Advances (NPAs) was 1.67% of their portfolio. Strong NPA position is largely driven by group-based individual lending model, with focus on income generating loans made to women and lending progressively higher amounts only to members who have built up a track record of good repayment, which taken together have led to low rates of default. Bandhan claims that all micro loan customers are insured so that if they pass away, their loan balance is paid off in full without their family needing or feeling pressured to repay the loans
• As at December 31, 2017, capital adequacy ratio was at 24.85% RBI requires a minimum capital adequacy ratio of 13.0% of total risk-weighted assets
• The Parent entity grew from India’s fourth largest microloan portfolio as of March 31, 2010 to India’s largest microloan portfolio as of March 31, 2012. As of now, over 90% of lending falls under Microfinance, which is a high yielding category

Credit potential in rural India –

• Although rural India contributes 47% of India’s GDP, its share in total credit outstanding is just 10%, in comparison with 90% for urban India as of fiscal year 2016. This extreme divergence in the share of rural areas in India’s GDP and banking credit is an indicator of the very low penetration of banking in rural areas
• Buoyed by the Government’s sustained efforts to bolster financial inclusion, the number of credit accounts in rural India grew at a 7% CAGR, with the number of deposit accounts rising at an 18% CAGR in fiscal year 2016 from fiscal year 2011. This growth was higher than the 5-years CAGR of 5% in the number of credit accounts, and 14% in the number of deposit accounts in urban India. Notwithstanding, the number of credit and deposit accounts in rural India was almost half that of urban India as of fiscal year 2016
• 2/3rd of total households are in rural India and the region wise region-wise asymmetry further bolsters the potential for credit growth. Northern and eastern regions have a lower share in total bank credit and deposits. Banking retail credit per capita in the eastern region is the lowest, and is five times lower than the southern region

As per latest RBI data, y-o-y credit growth as of February 2, 2018 was 11.0%

Microcredit sector potential and Bandhan Bank’s current standing –

• Industry size is pegged to reach ~ INR 1 trillion in next two years driven by rising penetration
• As per Bharat Micro-finance 2016, MFIN, CRISIL Research (November 2017), the gross loan portfolio (GLP) of MFIs grew at 51% CAGR from fiscal year 2013 to fiscal year 2017. This growth was fuelled largely by the growth in GLP of some large players, such as Janalakshmi Micro-finance, Bharat Financial Inclusion Ltd, Ujjivan Financial Services and Satin Creditcare Network Ltd
• CRISIL Research expects the MFI loan portfolio growth to be at around 16-18% annually in the next two years, much lower compared with the past four years, as rural areas in well-penetrated states mature and the focus of some top players converting into SFBs shifts towards selling other banking products
• Banks (including direct and indirect bank lending) account for approximately 60% share of the overall micro-finance credit in India
• As per he RHP, Bandhan Bank has the largest overall gross micro-banking asset portfolio, with ₹213.8 billion as of March 2017, (also counting gross advances, which includes IBPC/Assignment, in the microfinance segment). Amongst the banks (private as well as public), the outstanding loans given by Bandhan Bank is more than three times higher than its closest competitor, the State Bank of India
• Bandhan Bank’s loan book grew 35% in fiscal year 2017. Highest loan book growth has been registered by Bajaj Finance. Bank’s deposit growth was second only to IDFC Bank. The deposit growth for these two banks was the highest amongst their peers on account of their lower base, as they began to accept deposits only from fiscal year 2016

Cost of funds – 

• Average cost of deposits decreased from 7.72% to 7.09% (annualized) due to an improvement in CASA ratio from 27.22% to 33.22% for the nine months ended December 31, 2016 to the nine months ended December 31, 2017.
• Increase in CASA i.e. number of deposits led to lesser RBI/inter-bank borrowings (deposits are cheaper than borrowings from RBI/inter-banks), which in turn let to a decrease in overall cost of debt from 7.9% (in FY2017) to 7.24% (annualized) as of December 31, 2017
• ICICI Bank has a CASA ratio of ~50%, which makes it overall cost of funding to be the lowest (5.3%) in the industry. HDFC and Axis too have a similar CASA and a marginally higher cost of funding. Banks or financial entities which are not into deposits (i.e. “0” CASA ) typically have higher cost of funding
• Small Finance Banks with no CASA- AU Small Finance Bank and Janlakshmi Financial Services have high cost of funds of 10.3% and 10.4% respectively. MFIs – Satin CreditCare and Grameen Koota Financial Services cannot have deposits and hence have highest cost of funds @ 13.2%

Absolute Valuation

It is challenging to value BFSL using FCF methods since reinvestment composed of Net CapEx and Working Capital is hard to forecast for financial firms. Moreover, for BFSL it becomes all the more challenging due to the lack of operational history. I was wary of using the Dividend Discount Model (DDM), which again is very similar to FCF, but heavily depends on assumptions around payouts i.e. dividends. BFSL has not obviously paid out any dividends and it does not mention any proposed payout ratios explicitly in the Red Herring Prospectus.

For this valuation, I have used the Excess Return Model, which NYU Stern Prof. Aswath Damodaran has explained brilliantly in his book “Investment Valuation”. This method is relatively straight forward and cuts through layers of complexity. This method is quite intuitive with the idea that it takes the value of both current equity and forecasts of future excess equity returns

Value of Equity = Equity Capital invested currently (including Fresh Issue through IPO) + Present Value of Excess Equity Returns to equity investors; 

where Excess Equity Returns = (Return on Equity – Cost of Equity) * Equity Capital invested

This model requires us to estimate 4 important parameters –

1. Return on Equity (ROE): BFSL has an annualized ROE of 25.55% as of December 2017
2. Cost of Equity (COE): Hard to ascertain using CAPM since Beta is not available for an unlisted firm. Moreover, BFSL’s business model is different from a typical listed bank and MFI, which makes it problematic for us to consider the Beta of a peer firm. Nonetheless, we would assume a range of Beta value from 1 to 1.2 to estimate COE

CAPM:  COE = Risk Free Rate + (Beta of Stock * Equity Risk Premium)

When Beta = 1: COE = 6.9% +  1*5% = 11.9%

When Beta = 1.2: COE = 6.9% + 1.2*5% = 12.9%

Risk Free Rate (RFR) is given to be between 6.7% to 7.1% in the RHP, hence we assume RFR to be 6.9%

3. Beginning value of Equity: 4446.4 Crores in the beginning of FY2018 as available in the Balance Sheet
4. Dividend Payout Ratio: No dividends yet obviously. No explicit payout ratio mentioned in the RHP. Payout ratio assumption does not have a significant impact on the valuation using excess return model as it has in DDM. We assume a payout ratio of 5%

To get started, we need to make the judgement as to when BFSL would become a stable growth firm. Because of the under-penetrated microcredit sector and differentiated business model, we can assume a high growth period of 10 years (stage 1) wherein BFSL sustains its current ROE of 25.55% with a COE) between 11.9 to 12.9%. High growth period is followed by a period of stable growth (stage 2) wherein both return on equity and cost of equity fall and converge to let’s assume 10% i.e. there is no value gained or lost after 10 years, rather excess return generated in stable growth period is 0

The net income each year is computed as the product of ROE and beginning value of equity each year as indicated in the exhibit. Book value of equity each year is estimated each year by adding previous year’s equity to the retained earnings of the current year

Exhibit – Excess Return Model

Projected fair value of Rs. 206 per Share on a consistent ROE of 25.55% during the high growth period with Cost of Equity of 11.9%
The fair value reduces to Rs. 190 per Share on increasing Beta to 1.2 (i.e. Cost of Equity of 12.9%)

As we increase Beta, risk increases, and hence value per share further decreases.
Similarly, we can have a range of projected fair values, on changing our estimates of ROE. A 30% ROE throughout the high growth period bumps up the projected fair value to ~ Rs. 287 per share

Using Goal Seek to force the projected fair value to the issue price of Rs. 375 per share revere calculates the ROE to be 33.8% during the high growth period

What this means is that any ROE assumption above 33.8% would make the issue under-priced

No doubt, this method is very simple when compared to the full-blown financial modelling we did in using FCF method of valuation we saw in the valuation of LT Foods . Limited financial history (as presented in the RHP) constrains our ability to work with past data and project it into the future. This again makes the use of other valuation models perhaps untenable since they require a lot of assumptions to be taken. Hence, this makes the straight forward Excess Return Model very powerful to use for Financial Services firms specially when operational history is limited.

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