A Method To Value Banks and Financials (or every other company)

Plus: A construction company trading at 3x FCF, another one trading at 5x FCF

EV/EBITDA or EV/FCF are one of my favorite valuation tools, because with these you can accurately determine the current valuation or a fair valuation pretty quickly. However, you can’t use these metrics for banks and other financials, because their comparatively large debt distorts the output and makes undervalued companies look overvalued & vice versa.

What should yo do then? Use deposit premiums instead.

Deposit premiums

These are among my favorite valuation metrics for a bank, because you can determine the premium over tangible common equity you are paying for deposits (or loans, or whatever you wish to use). They are used majorly by acquirers, just like EV/x. Read Gator Capital’s letter here to learn more about these and a quick valuation for major banks based on deposit premiums (sidenote: Gator is a really good resource for learning about banks and financials, most of my sector knowledge comes from them).

The formula is: (Premium) * 100 / Deposits

The premium is market cap subtracted by tangible common equity. You can also use it in inverse by deciding your own premium and then getting to a market cap.

Here’s a deposit premium study based on the current valuation of one of my favorite banks, IDFC First (India):

You may note deposit premiums are higher in India, as growth, NIMs and returns on capital are higher.

Premiums/x

However, we’re not here to talk about deposit premiums, many have elucidated on that topic already. I aim to introduce a new metric to value banks and financials: Premium/FCF or Premium/Net Profit. It will be obvious to many of you readers that companies with better liquidity, solvency, ROICs, NIMs will have higher premiums and a higher Premium/x.

It is important in my opinion to use this metric because you need to know how much and what you’re paying for. Here’s a valuation based on this metric for the above bank, IDFC First:

You can see in this case that the premium is almost equal to FCF (which is why in my previous valuation for IRFC I used NAV + FCF or NAV + estimated FCF).

Here is a comparative valuation of major Indian private banks by premium % and premium/FCF:

You can obviously spot the undervalued and overvalued banks here. What’s interesting is banks which look overvalued on traditional metrics like P/E, P/FCF, P/B etc look undervalued here - examples being IndusInd, CSB, RBL. I’m going to buy RBL as soon as the market opens tomorrow, because it’s a great bank with good asset quality at a cheap price. It’s up to you to choose which you want to buy, but I’d recommend you research Karur Vysya, the most undervalued here, before you buy because it has been dealing with bad loans and other issues.

I did not include DCB and City Union here because the relevant data was not available on their IR pages and other sources don’t have it in the format needed. I’ve been interested in these so if anyone can get me the relevant data or the finished valuation please send it along and I will post it.

You can use these same metrics for financials, for insurers use float premium %ages or premiums/FCF. The best metric is float premium % divided by returns on float invested.

In Other News

I was alloted IRFC shares in the recent IPO, I posted about here and I’m excited to hold them. The stock is down on listing today, indicative of the bearish sentiments prevalent now.

IRCTC, the ticketing and catering arm of the Indian Railways, just released earnings. Their net profit is down 62%, and while I didn’t look at the share price, I believe it has gone down. Is this the time to buy? Or should we wait for a lower price? Looking forward to your comments.

HG Infra

A quality construction company, HG Infra is trading at 3x FCF (TTM). You can go through their annual report to find their Cash Flow Statement here. I believe the company is very undervalued as it just released earnings where it doubled its profit, has mid double digit margins and returns on invested capital. Full disclosure: I own shares and will benefit from a rise. I’m excited to hold and feel very bullish about the company’s prospects and share price.

Ashoka Buildcon

This is yet another construction company trading at 5x FCF. Although it had its issues during the lockdown, it has since recovered. The management is good, the order book is solid and while it may be over leveraged, I believe the company can meet its obligations. I’m looking for maturity structure and debt coverage data for the company (like the stats posted by APSEZ) to confirm or disconfirm my belief, please send them to me if you have them. You can find their financials here.

Requests

If anybody has recent letters by Scion Asset Management (Michael Burry’s shop) or the letter archives of Punch Card Capital (Norbert Lou), Appaloosa (David Tepper) or Gotham (the quant one, run by Joel Greenblatt), please send them along. I’m really interested in reading these.

If anybody knows how to access Santangel’s Review archives or has some editions they could share, I would be honored.