In the early part of the decade, there was little interest in banking stocks at the Karachi Stock Exchange; investors mostly focused on the more heavyweight scrips such as PTCL, HUBCO, PSO, FFC and the likes. This was the pre-privatisation timeframe and saw the listing of National Bank of Pakistan at the stock exchange through a 10 percent public offering.
It was generally accepted that banks could not be valued using free cash flows or price/earnings (P/E) multiples given the leveraged nature of the balance sheet and volatility in earnings due to hard-to-estimate intangibles.
Therefore, the best way to value banking stocks was generally assumed to be utilization of the banks' book value per share and attaching a particular multiple to that book value per share.
The major focus remained on arriving at a justified price/ book value (P/B) multiple based on peer analysis and comparing respective ROEs (return on equity) to generate a justified P/B multiple. For example, if one was valuing MCB, one would use two methods to arrive at a consensus fair value.
Firstly, one would look across the sector and see what sort of multiples are the rest of the banks in the sector trading at, take an average of that multiple and then apply it to XYZ bank's book value to arrive at a fair value.
Secondly, one would also take the expected RoE for the current year and divide it by the required rate of return (as per capital asset pricing model) to arrive at a multiple. For example, if MCB's ROE is 25 percent and the required rate of return is 20 percent, the P/B multiple would be calculated as 1.25x, and then multiplied with the bank's book value to arrive at the stock's fair value.
ADDING DIVIDENDS TO THE MIX
Banking sector profitability began to shoot up following the loosening of monetary policy by the State Bank of Pakistan (SBP) between 2003-2005. Decline in interest rates led to a period of sustained money supply growth well above 15 percent per annum, resulting from growth in private sector credit. Not only was the industrial sector borrowing to finance expansions, but the foundation for aggressive consumer lending was also laid in this time period.
As interest rates came down, banks not only increased their lending volumes, but also began to take advantage of increases in values of investments (bonds, T-bills, stocks, etc.) to record unrealised and realised capital gains.
Being newly, and highly profitable, the banking sector also began to be looked at as a dividend-paying investment alternative, especially as capital adequacy ratios of the listed banks began to improve and new banks (UBL and HBL) began to get listed as part of the privatisation programme.
Banks were now also valued using the much-coveted Dividend Discount Model (DDM). However, the one major criticism of this valuation methodology emanated from the little weight it assigned to dividends and its heavy dependence on a relatively arbitrary terminal value. Terminal value here means the value of the present value of all future dividends in perpetuity, calculated by growing the last estimated dividend on the forecast horizon at a terminal growth rate.
FOREIGN INVESTORS'
INTEREST & NORMALISED ROE
The year 2006 was the time when foreign portfolio investors began to take an interest in Pakistan's stock market. With an improving economy, which had grown 9 percent in the previous year, a stable exchange rate, and controlled inflation levels, Pakistan offered an attractive lower-priced alternative as an investment destination.
It was often quoted that the closest one can come to taking exposure to an economic growth story in terms of equity investment is through the banking sector, since it mirrors the trends prevalent in the economy.
As foreign investors arrived and began taking exposure in Pakistan's banking sector, especially the large listed banks such as MCB and NBP, it became apparent that there was a disconnect between the valuation methodologies used by local analysts and those put into practice by foreign fund managers and analysts.
It seemed as if foreign investors were more bullish on banking sector, with higher fair values, as compared to the local analyst community.
Since 2006-2007 to date, the valuation method favoured for banking stocks in Pakistan has been more in line with global and regional practice. The method basically recreates calculation of a justified P/B multiple, while also allowing contribution from the dividend discount model (DDM).
Taking the dividends for the forecast horizon and discounting them using the required rate of return gives one portion of a banking stock's value. However, the major portion of the stock's fair value is derived through a three-step process:
i) Determination of Normalized ROE level based on earnings forecasts. This is determined by breaking down the ROE into its sub-components via the DuPont method.
ii) Using the formula (ROE - g) / (k - g) to calculate a value for justified P/B multiple; where g = terminal growth rate and k = required rate of return on equity.
iii) Multiplying the calculated justified P/B number by the bank's book value to generate a terminal value.
This terminal value is then added to the present value of the dividend stream calculated earlier to arrive at a fair value for that particular banking stock.
CONCLUSION
It seems that as the market has got more sophisticated due to the influx of foreign investors, then so has the valuation methodology.
From the basic universal methods of P/E multiples and simple DDM, the market has graduated to more complex and detailed valuation models. The beauty of the normalised ROE calculation using DuPont method is that it isolates each sub-component and allows the analyst to trace any error that may have occurred, and even serves to explain the contribution of various key heads towards profitability.
It is also intuitively comprehensive in the way that it takes the required pieces from the profit & loss accounts and balance sheets of the banks.
There may be further evolution in the methodology used to value banking stocks going forward, as banks' balance sheets get more sophisticated with time (e.g. adding on assets/liabilities in the form of derivatives), in line with other developing economies.
However, at present Pakistan's banking sector remains heavily focused on higher spreads due to an 'unaware' depositor-base who is unable/unwilling to go through the hassle of demanding optimal return.
Therefore, it seems that since DuPont-led justified P/B calculation is relatively straight-forward, it will continue to be the method of choice for most analysts covering the banking sector in Pakistan.
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Sample DuPont Analysis Methodology
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UBL MCB NBP
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Avg. IEA Yield 10.18% 11.45% 9.15%
Avg. IBL Cost -5.17% -4.04% -5.42%
NIM (% of avg. lEA) 5.47% 7.93% 4.52%
IEA / Assets 97.6% 94.7% 96.6%
Margins (% of avg. Assets) 5.34% 7.51% 4.37%
Non-IR contribution 25.2% 12.0% 27.3%
of this-fees 13.5% 8.2% 16.9%
of this dealing 2.8% 0.8% 5.7%
of this other revenues 8.9% 2.9% 4.7%
Non-IR/Avg. Assets 1.80% 1.02% 1.64%
Revenue/Assets 7.14% 8.53% 6.00%
Cost/Income 39.0% 35.4% 43.3%
Cost/Assets 2.79% 3.02% 2.60%
Pre-Provision ROA 4.35% 5.51% 3.41%
LLP/Loans -2.49% -2.14% -2.23%
Loan/Assets 63.1% 57.0% 56.1%
Other Income/Assets -0.2% 0.6% 0.4%
Operating ROA 2.8% 4.3% 2.2%
Pre-Tax ROA 2.53% 4.87% 2.53%
Tax Rate -34.5% -33.1% -18.3%
Return on RWA 1.66% 3.26% 2.07%
RWA 2.12% 4.65% 3.12%
Equity/Assets 8.6% 13.5% 12.6%
ROE 19.4% 24.2% 16.4%
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LEGEND
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IBL: Interest Bearing Liabilities IEA: Interest Earning Assets
NIM: Net Interest Margin LLP: Loan Loss Provisions
IR: Interest Revenues ROA: Return on Assets
RWA: Risk-Weighted Assets ROE: Return on Equity
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Source: Company Reports 2009 results
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The writer is a Director at Invest & Finance Securities. He can be reached at khalid.iqbal@investfinance.com.pk