27 April 2017

Bank Nifty Valuations – All heated up

As on 25th April, 2017 the Bank Nifty (Nifty Bank as it is now known as) closed at 22,054.7. At this closing the valuations of the index were as given below:
  • Price to Earning Ratio: 30.28
  • Price to Book Ratio: 2.86
  • Dividend Yield: 0.68%
  • Earning Per Share: 728.36 per share
  • EPS Growth (YoY): – 19%
Let’s dig into these numbers to understand what’s happening in a better way.
Price to Earning Ratio:

As visible from the chart, the PE levels are at all time highs – They have surpassed the 2008 peak and are trading at historical highs.
We have analysed the data of the index since 2003 and the mean PE level is 15.02 with a standard deviation of 5.36. Currently, the index is trading above it’s 2SD level (Mean + 2* SD) and it has been above it’s 2SD level for almost a year now. Since, 2003 the index had traded above its 2SD only 10% of the times! This time, the index has stayed above the 2SD band for an extremely long time. Look at the below chart for a visual understanding of this point.

The above chart will give you a fair idea about the undervalued zones from where the market picks up and the overvalued zone from where the market usually corrects. Once in 4-5 years, you will get the index at the -1SD (grey) zone. Just buy the best banking stocks at that time. And sometimes, you will also find the index at the +2SD zone. In 2007, the index had crossed the +2SD mark and stayed above that for quite sometime. We saw a deep correction after that. So will we see a crash in banking stocks now?
P/E is has two important constituents – price and earnings. The P/E will go up when:
  • Index goes up faster than earnings
  • Index goes up with no change in earnings
  • Index goes up with a fall in earnings
In the current scenario, the earnings have fallen because of the NPA hit that the banks have taken.

Having peaked out near Rs 1,000 per share, the EPS of the Bank Nifty index fell close to Rs 644 in just a quarter because of the NPA hit that banks had to take. That is why the PE spiked up sharply! Is there more room for earnings to fall? Or is worst behind us? Lets understand the expectations that the market has built.
The market had digested the fact that this is a one-off hit that the banks have taken and things will get normal soon! Earnings will grow at a rapid pace because any economic growth usually sees the banking industry spiral into a boom and the market sees India on the verge of a big economic boom waiting to happen in the not so distant future.

The above chart shows the EPS growth rate which had slipped to -30% and is now languishing at -19%. The P/E and growth are poles apart from each other as shown in the below chart. Eventually, the PE and the growth rate will have to come closer. As per Bloomberg consensus data, the EPS of the Bank Nifty index is expected to be Rs 959 and Rs 1229 for 2017 and 2018, thus signalling a growth rate of 17.9% and 28.2% in this period. This high growth expectation explains the high PE ratio that the index is commanding. The earnings of bank Nifty constituents makes up nearly 25% of the earnings of the Nifty index.

So the fair range of the Bank Nifty index is a P/E between 15-17. How does it come back to those levels?
  • By crashing 50%
  • By seeing EPS double from current levels
Neither of these two events look probable in the current scenario. Over the next three years, we can witness good growth rates being posted by banks in terms of earnings and the index being range bound OR cooling off by 15% to 20% from current levels. As you can see in the above chart – the EPS growth rate picked up post 2010 to 20%-22% p.a. YoY and at the same time, the PE levels cooled off.The index was largely range bound for those years.
Apart from earnings, the book value and dividend yield are the other ratios we look at to check valuations.

The dividend yield of the Bank Nifty index is at historical lows and shows stretched valuations.

Book value of banking companies is an important ratio too look at while evaluating them. The market is clearly paying a high premium on the book values of banking stocks. While we are nowhere near the highs of 2008, we are inching close to the highs of early 2011 and 2015.
The constituents of the Bank Nifty index are:
Axis Bank Ltd.
Bank of Baroda
Canara Bank
Federal Bank Ltd.
HDFC Bank Ltd.
ICICI Bank Ltd.
IDFC Bank Ltd.
IndusInd Bank Ltd.
Kotak Mahindra Bank Ltd.
Punjab National Bank
State Bank of India
Yes Bank Ltd.
You can now see why the index is at all time highs when some of the PSU banks are going into doldrums! The Bank Nifty index only has the top performing banking stocks which are shuffled frequently. Since 2011, we have seen the following stocks move in or out:
10-10-2011Oriental Bank of CommerceExclusion from Index
10-10-2011IndusInd Bank Ltd.Inclusion into Index
27-04-2012IDBI Bank Ltd.Exclusion from Index
27-04-2012Yes Bank Ltd.Inclusion into Index
28-03-2014Federal Bank Ltd.Inclusion into Index
28-03-2014Union Bank of IndiaExclusion from Index
31-03-2017Bank of IndiaExclusion from Index
31-03-2017IDFC Bank Ltd.Inclusion into Index
Are these top performing banks expensive and ready to crash?
Let’s look at the historical valuations that these banks have commanded over the last 10 years. First, we look at Kotak, Yes and HDFC Bank shares. The below chart shows their PE levels since mid-2006.

Most of the “Ben Graham” styled value investors would including you and me would have missed these banks in 2006-09-12-14 because of the high PE levels. These shares have given humongous returns over the last so many years purely based on earnings growth. There has been no serious P/E expansion in any of them. Kotak Mahindra Bank’s P/E shot upto 220 and later came falling down! An investor back then would have had a nightmare. The share runs up 5- 6 times and comes back crashing.
The price to book is an important figure when evaluating banking stocks. So what does the PB Ratio tell us? Are these three banks trading at a premium to their long term PB ratios?

None of these banks are trading at premiums which should be of concern to any investor. All of them are trading at par with their long term averages. Ofcourse, the investors are still paying this premium because they expect these banks to continue posting the strong numbers that they have been posting ever since. The question is till when will these results pour in? The future lies in Private Sector banks and the consolidation of the private sector banks. So many banks exist today, we will see the numbers go down over a period of time as banks merge and consolidation happens.
So which stocks from the Bank Nifty Index could drag the index down?

Kotak, HDFC, IndusInd and YES have grown their topline at a CAGR of more than 14% over the last 5 years. Other banks have grown their revenues too, but at a slower pace. Let’s now look at their profits.

All of the banks highlighted in green have grown their profits at a higher rate than their income. This shows that their margins have expanded over the years. The problem lies with the other banks. Except for ICICI, the rest are in negative territory.
If the EPS of the index has to improve, then these banks will have to show a super fast pickup in their profits (NPA issue comes into play here). The share prices of these banks has more or else remained flat over the last three years despite seeing a fall in earnings. So, these banks are dragging the earnings of the index down while the Kotaks and the Yes and the HDFCs and IndusInds pull the index to all time highs. This is why we are seeing such high valuations.
Going forward, we don’t see a major price fall in the shares of Kotak, Yes, HDFC and IndusInd. SBI is at all time highs while its earnings continue to trend lower. The marker is riding on the “hope” of earnings recovering in these banks. Interesting times lie ahead in the banking sector. Even if we say that ICICI, Axis and other names here might correct in terms of share price, we can be wrong. The Bank Nifty might be rejigged and the laggards will be replaced by new names like RBL Bank, IDFC Bank, etc. So, more than being bearish on the Bank Nifty Index, we are bearish on some of it’s constituents that could get kicked out of the index and see a fall in their share price.
Disclosure: We had recommended YES Bank to our clients in October 2013 at an average price of  67-72 and some of our clients continue to hold positions in Yes Bank.

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