Beyond the glimmer of attractive dividend yields, there lies a dim reality for banks. The market still fears domestic debt restructuring is a very real possibility. Consequently, banks continue to trade at steep discounts.
After my last blog, a couple of people inquired: how can we quantify the
‘debt restructuring’ discount for banks? Before diving into this, one has to
first provide a background of valuing banks.
Historically,
banks had been valued using a basic dividend discount model which most or every
finance/economics undergraduate would be familiar with. Often also called the
‘Gordon growth model’ (GGM). However, the 2008 financial crisis revealed the
fragility of using GGM for valuing financial companies.
The main issue with GGM (for valuing banks) is that it
provides or incorporates no information on the regulatory capital of a bank. A
bank might be paying really high, regular dividends. However, if those
dividends are backed by significantly risky investments, the bank might be left
undercapitalized.
This is where an equity reinvestment model jumps in. In such a model, free cash flow is found by taking net income and netting out investment in regulatory capital (tier 1). Then to obtain net income, you work your way back. You can look at the chart below to understand this (made by Aswath Damodaran):
So, in this model, the key determinants for
determining the value of a bank are cost of equity, growth rate (banking assets
growth rate), return on equity and target tier 1 capital ratio.
Using this FCF model, you can predict the fair value
of a bank. However, you can work your way back and find the implied target tier
1 capital ratio. Or what the market thinks a bank’s future tier 1 capital ratio
would be.
For the first
three key determinants, we can use historical averages. Cost of equity
currently stands at 28% (22% risk-free rate plus a historical 6% ERP), while
long-run cost of equity would be 14% (8% historical average risk-free rate plus
6% ERP).
Similarly, banking asset growth rate has stood at 16%
for the past five years but 10% in the long run. Lastly, ROE can be computed on
a bank-to-bank basis. For instance, SCB’s 5-year average ROE is 25% which is
heavily inflated due to windfall profits in CY23. Historically, banking sector
ROE has been 18%.
Based on this, and SCB’s current Tier 1 capital ratio
of 18%, the market is expecting that SCB’s tier 1 capital ratio (in perpetuity)
would be 3%. That means a significant wipeout of capital which would push SCB’s
CAR below SBP’s minimum requirement. This cements the view that the market is
still pricing in a significant debt restructuring discount for banks.
The story is very similar for other premier and
non-premier banks. So, if interest rates start coming down, that would actually
bode well for banks. Why? Because every 100 BPS reduction in interest rates
leads to a reduction in debt servicing costs of approximately Rs 250 bn for the government.
This would reduce the chances of federal debt
restructuring as the government would obtain more fiscal space. Moreover, is
such a steep discount justified for banks when domestic federal debt
restructuring has never taken place in Pakistan? Even while external debt
restructuring occurred, local/rupee-denominated debt was never restructured.
Markets have a tendency to underweight unlikely or
tail events. However, this might be a case of the market overweighting a tail
event – domestic debt restructuring. Perhaps, one should be overweight on
banks?
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