Abstract
The case study is about the valuation of one of the profitable banks in southern India, City Union Bank Ltd (CUB). The bank was adjudged as the ‘best small bank’ by BusinessWorld’s Best Banks Survey 2016. The bank has seen a meteoric rise in its stock price during the period 2013–2017 and outperformed other banks in the industry in terms of non-performing assets (NPA), return on assets, capital adequacy ratio (CAR) and so on. The stock has been attracting the attention of the investing fraternity. An analyst is assigned the job of valuing CUB’s stock. Residual income valuation method is employed for valuation and facilitates in decision-making. The valuation exercise involves projection of financials and estimation of cost of equity, terminal growth rate and residual income. The case also considers other key parameters associated with the banking sector in decision-making.
Introduction
On 15 March 2017 (Wednesday), Avinash Thamada, an MBA (finance) from a premier B-school in India was appointed as an analyst in a leading investment banking firm. His first assignment was to advice one of the clients of the firm on whether to invest in City Union Bank Ltd (CUB) at the current market price or not. The client had zeroed in on CUB as it was ranked as the best small bank in the BW Businessworld’s Best Banks Survey 2016. The market price as on 31 March 2017 was ₹137. The share price of CUB has seen a dramatic rise during 2013–2017 (refer to Figure 1). In the wake of the meteoric rise, Avinash Thamada wondered whether advising his client to invest in this bank at the current market would yield any significant returns. Determining the intrinsic value of the stock was the way out to comment on CUB’s stock valuation. The decision would of course factor other parameters in addition to the valuation exercise.
Indian Banking Scenario
The Indian banking sector has seen a tremendous growth since 1992. The sector has witnessed the emergence of the private sector and new generation banks. These banks continue to co-exist with public sector banks to offer quality services to the common public through a mix of conventional and modern methods of banking. Thanks to the Government’s policy on financial inclusion and inclusive growth combined with impetus to digitization, the number of banking outlets in rural villages doubled during the period of study (refer to Table 1). The Indian banking sector is plagued with a major issue, non-performing assets (NPA). The bulk of bad loans are not cases of outright frauds. The Economic Survey of 2016–2017 states that bad loan problem is mostly the result of factors extraneous to management.
Factors such as global financial crisis, delay in land and environmental clearances for projects, near collapse of steel prices, fall in spot rate of power and adverse course judgements on 2G spectrum and coal block allocation have all contributed to the bad loan problems. Figure 2 shows that the banking sector has provided more loans to non-food sector than to agriculture and others. Among the non-food sector, exposure of banks is more towards infrastructure sector such as steel, power and telecom. The NPA (gross and net) and slippage ratios of the Indian banking sector have increased during 2013–2017 (refer to Table 2). The Reserve Bank of India (RBI) has been taking proactive measures to control the burgeoning problem.
A Glance at Key Statistics of the Indian Banking Sector
Key Parameters: CUB Vs Indian Banking Sector
About CUB
The bank was established under the banner Kumbakonam Bank Ltd and registered itself as a limited company in the year 1904. It commenced its operations as a regional bank and soon cemented its place in the delta district Thanjavur. The first branch of the bank was opened in the year 1930 at a place called Mannargudi. Subsequently, within a span of 25 years branches were opened in the neighbouring districts and towns of Thanjavur. In the year 1945, the bank’s name was included in the Second Schedule of RBI Act, 1934. In the year 1965, two local banks, namely, The City Forward Bank Limited and The Union Bank Limited were amalgamated with the bank under a scheme of amalgamation. The outcome of the amalgamation process resulted in opening of more branches down south of Tamil Nadu. Subsequently, the bank was renamed as The Kumbakonam City Union Bank Limited.
The bank opened its first branch outside Tamil Nadu in Bangalore, Karnataka in 1980. In 1987, the banks’ name was changed to City Union Bank to maintain its national image. By the end of 1989, the bank had established branches in Andhra Pradesh and had its own staff training college. The bank was also permitted to deal in foreign exchange as an authorized dealer. In 1990, the bank computerized all its branches and started offering core banking solutions.
The bank started offering fee-based services such as marketing export credit insurance, remittance of funds to and from abroad and dematerialization services. The bank was permitted to sell insurance products as a corporate selling agent by The Insurance Regulatory and Development Authority of India.
The bank is in 111th year of operations and is quick to embrace technology with the introduction of CUB Lakshmi, a robot which uses artificial intelligence to answer queries of customers on a pilot basis. The current Managing Director and CEO of the bank is Dr N. Kamakodi.
About Financials
Tables 3 and 4 show the financials for the period 2013–17. One of the most profitable private sector banks in India is CUB. It witnessed a 10 per cent compound annual growth rate (CAGR) in deposits during the period 2013–2017. The low deposits (i.e., current and savings accounts) have grown at a remarkable rate of 20 per cent CAGR. This increase has resulted in the cost of funds smoothing down significantly from 7.4 to 5.38 per cent (Up to 31 December 2017). The net interest margin (NIM) has also grown from 4.38 to 5.45 per cent respectively (refer to Table 2). The non-interest component of the total income also shows an increasing trend during the period of study. In terms of asset quality, the bank was able to maintain its NPA level in the range of 1 to 2 per cent consistently, thus indicating the efficiency of managing its assets. The return on assets (RoA) and return on equity (RoE) have also shown increasing trend during 2013–2017 (refer to Table 2). The bank has outperformed the banking industry averages in aspects such as NIM, RoA, NPA, CAR and slippage ratio (refer to Table 2).
Profit and Loss Account of CUB (₹ in crores)
Balance Sheet of CUB (₹ in crores)
About Business Mix
In terms of business mix, CUB has a conservative loan book wherein, 76 per cent of the loan book is towards agriculture, micro, medium and small medium enterprises (MSMEs), trade services and gold loan. Loans to MSMEs have resulted in lower NPAs as they are additionally collaterized by residential property and personal guarantees. The bank has also minimal exposure to consortiums, multiple banking arrangements or to infrastructure. 1 The remaining 25 per cent is towards various industries such as textiles, paper and paper products, metals, automobiles, housing finance and commercial real estates. The form of advances provided comprises of cash credit and demand loans, term loans, bills purchased and bills discounted. A total of 65 per cent of the advances are in the form of cash credit and demand loans, 34 per cent are term loans and 1 per cent in the form of bills discounting and purchasing.
Valuation: Approaches
Avinash Thamada in his days as an MBA participant had learned various approaches to valuation of banking and non-banking companies in a course in valuation. The different approaches include economic value added/economic profit (EVA), market value added (MVA) and residual income (RI) methods (Penman, 2014).
A US-based firm, Stern Stewart & Co first developed EVA as a tool. It is a concept that looks at the net profits generated by a company for its shareholders measured over and above the expected return on capital deployed by the shareholders. Stern Stewart makes a number of adjustments to the book profits to correctly state the economic profits. Since there is ambiguity in the adjustments to be carried out in book profits, EVA as a tool may not be preferred for valuation exercise. Moreover, EVA is a useful tool for performance appraisal of divisions cost centres.
Increase in market capitalization over the capital value and judges value creation heavily on market judgement is looked by MVA. The drawback of the method is that it fails to make an allowance for market vagaries and sentiments.
The RI valuation approach involves addition of the current book value of a company to the present value of its future residual income to determine the company’s equity valuation. It represents the excess of profits over the required rate of return. This method works on the premise that investors expect a rate of return that compensates for their cost of capital with commensurate level of risk. Hence, the term residual is referred to the amount by which profits were expected to exceed the required rate of return on equity (Parasuraman, 2014).
Analysts generally prefer to use the RI valuation method for banking companies where the book value of assets is closer to the fair market values. Most of the assets of banking companies are in the form of loans and advances in the balance sheet. Since the books value of the assets is the same as their fair market values, RI method is preferred for valuation of banks. (Darwar et al., 2015)
Avinash Thamada was convinced that the RI approach to valuation of CUB’s stock was relatively appropriate and decided to go ahead with the valuation exercise.
Forecasting Financials
For forecasting exercise of the financials, it is vital to have a futuristic outlook across the key growth parameters. It was found from the presentation of CUB management team to investors that the loans and advances were likely to grow at 15 to 20 per cent until 2020. To forecast the deposits, it is assumed that CUB would be able to maintain its advances–deposit ratio in line with the previous year. The growth in NIM and cost income ratios are assumed to be stable. Despite the challenges faced by the banking industry, CUB is confident of maintaining the existing asset quality and performance.
CUB’s beta value is 1.24 (author’s calculation) and the market risk premium is 5.1 per cent. 2 For risk free rate, 10-year treasury yield of Government securities is considered. The rate is 7.17 per cent which is sourced from the RBI’s website. The capital asset pricing model (CAPM) is used to calculate cost of equity which is the discounting rate under RI method. CAPM method is relatively superior as it captures the systematic risk of investments. Cost of equity is taken as the discounting rate because the RI model is derived from dividend discount model.
Footnotes
Acknowledgements
The author wishes to acknowledge Dr. N. R. Parasuraman, Director & Professor-Finance, Shri Dharmasthala Manjunatheswara Institute for Management Developement for his valuable inputs while developing the case.
Declaration of Conflicting Interests
The author declared no potential conflicts of interest with respect to the research, authorship and/or publication of this article.
Funding
The author received no financial support for the research, authorship and/or publication of this article.