RBL Bank Valuation: Bank or Banker?

It may come as a surprise to some of you that RBL Bank, despite having caught the attention of the media only a few years ago, is actually a considerably old bank. It was incorporated in Kolhapur, Maharashtra in 1943 as 'Ratnakar Bank'. It has come a long way since then. In line with its re-branding to 'RBL Bank' in 2014, it seems to have adopted a new and lucrative business model.

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The Company

RBL Bank is one of India’s fastest growing private sector banks with an expanding presence across the country. The Bank offers specialized services under six business verticals namely: Corporate & Institutional Banking, Commercial Banking, Branch & Business Banking, Retail Assets, Development Banking and Financial Inclusion, Treasury and Financial Markets Operations. It currently services over 6.5 million customers through a network of 324 branches, 993 business correspondent branches (of which 226 banking outlets) and 341 ATMs spread across 21 Indian states and Union Territories.

It is currently being led by Mr. Vishwavir Ahuja. He is an experienced person in the Banking Industry with close to 36 years under his belt. He joined RBL Bank in July 2010 when it was a small, regional, southern Maharashtra based old-age private sector Bank. Prior to joining RBL Bank, Mr. Vishwavir Ahuja was the Managing Director & CEO of Bank of America, India from 2001 to 2009. At Bank of America, Mr. Vishwavir Ahuja successfully managed assignments in USA, Hong Kong and all four regional offices in India. Mr. Vishwavir Ahuja held various positions in the Credit and Risk Management Group, Treasury and Foreign Exchange, Corporate Planning and Finance, and Head - Corporate and Investment Banking, before eventually becoming CEO at the age of 41. His impact on the bank is quite visible. It is no coincidence that he has won the acclaimed EY ‘Entrepreneur Of the year – Financial Services' in 2017.

Coming back to the firm, RBL Bank is being touted as the 'next HDFC Bank'. Regardless of that statement being true or not, RBL Bank does have an interesting thing going for it. Its collaboration with Bajaj Finserv in the card business has been considerably lucrative. Combine this with the MFI business, their planned 'Could Finance' project, and we have the approximate future business strategy of RBL Bank in hand. Considering how the market penetration for both of these segments is low, there is no question of growth here. The question is: How much will be the growth and how risky will it be? Make no mistake, RBL Bank is still a traditional bank in some sense--in fact, 50% of its Revenues come from Corporate and Retail banking as of today. So for the lack of a more inclusive method, both the lines of thought can be considered separately.

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The Industry

RBL Bank largely plans to expand drastically in two segments - Credit Cards and Micro Loans. As discussed above the market opportunity for both these segments is massive in India.

Credit Cards

According to the World Bank's Global Findex, at least one-fifths of people in developed nations use Credit Cards to transact. That is to say, the average Credit Card Penetration in the developed countries in 20% or so. In countries like the United States of America, that ratio goes north of 40%, which shouldn't be a surprise. What's surprising, however, is that a country as developed as India is, sports very low Credit Card penetration rates.

If you are a salaried employee, you may very well agree with this. Indians are largely reluctant about using Credit Cards or any sort of Credit in general (Apart from the obvious Education or Housing loan).

Micro Loans

There's no need to discuss this topic at length. Pretty much everyone who has a little knowledge about the demographics and the credit situation in India can conclude that the penetration for microfinance in India is abysmal. IBEF has put up a short document titled "Macro Potential for Microfinance Industry", highlighting the opportunities in this space. 

Traditional Banking

Unless we jump the gun, it is not be forgotten that RBL Bank is still traditional bank is a lot of senses. This is not a bad news, however. Credit penetration in general is low in India. A 2017 study by the RBI showed exactly this:

So while it is great the RBL Bank is trying to explore new market opportunities, there's nothing intrinsically wrong with going the traditional banking route too. After all, value creation in a company is all about converting opportunities into business.

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Additional Information

If you want to understand more about RBL Bank's business and numbers, I suggest these two excellent research reports, written by HDFC Securities and Motilal Oswal. RBL Bank's own Investors Presentation post their latest results is also revealing.

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The Numbers

I have added the following numbers from RBL Bank's latest full year results.

The following are the notes on how some of these numbers were included.

Note: Risk-free Rate

India's Risk-free Rate (The 30-year GOI Bond Rate, as I consider it) has slid considerably since the last time I valued a company. It currently stands at 7.34%:

(Source: World Government Bonds)

Note: Beta, Standard Deviation and Indexed Returns

I generally calculate Beta, Standard Deviation and the Indexed Returns for a valuation by myself (Although there's not much harm in choosing to pick up the numbers from a simple Google search):

(Download RBL Bank - Beta and Standard Deviation)

Note: Dividends

I have taken the latest results for RBL Bank. However, a Dividend is yet to be announced for the year. Hence, I have taken the liberty to assume that the DPR will remain in line with what the bank has been paying the past few years (Around 15% and change).

Note: Minority Interest

RBL Bank holds a subsidiary by the name of Swaadhar Finserv. As per the usual drill, I have removed that portion of the company's value that the bank does not hold (They hold 60.48% of Swaadhar Finserv - so the Minority Interest being 39.52%). I have valued Swaadhar Finserv at 3 times their Book Value.

Note: Number of Shares

You may notice that in addition to RBL Bank's current outstanding shares of ~42 Crores, I have added another ~10 Crores. Here's why: RBL Bank is fond of diluting its equity base. I'm not even talking about the IPO. But even post it, there has been considerable amounts of dilution.

In fact, in Axis Capital's 2019 Investment Conference (Which got over very recently), RBL's Mr. Rajeev Ahuja (Head - Strategy, Retail & Financial Inclusion) and Mr. Ramesh Ramanathan (VP - Finance & IR) presented about their bank. In it, they claimed that the bank will be raising new equity capital of Rs. 3,500 Crores in 2020 and 'does not expect to raise equity for the next 2 years if growth rates stay a 30-35%'.

I suppose you will agree with me when I say that RBL Bank plans to raise equity capital at least twice in the near future. The least I can do to incorporate this information into the valuation is the following:

The first figure is already given by the management. The second round of equity dilution, I assumed would be in line with the growth in Book Value of the company (About 10-11% a year). The PV of both these dilutions i.e. Present Value in 2019 would be ~Rs. 6,685 Crores. At the CMP of ~Rs. 670 (For the lack of an explicit selling price), it means that about ~10 Crore shares should to added to RBL Bank's count of outstanding shares to account for the dilution.

Note: Cash Vs. Cash Flows

RBL's newfound enthusiasm in Credit Cards and MFI isn't without a cost. For the last 5 years, RBL Bank has indeed been making a loss on their pure financing side of the business.

So, how are they ending up with the generous amount of the profits they are reporting? Ah, the devil is in the details. Apart from traditional financing, RBL Bank does a couple of other things. They trade in securities, invest in bonds / securities and has also put up deposits with the RBI (Which is mandatory, however) which earn them extra income. Without these additional activities, in short, RBL Bank would report a Net Loss. Here are the relevant numbers from the 2017-18 Annual Report:

There's nothing wrong in this. Many banks having additional lines of business do it too. So, what's the catch? The catch is that now I have two options:

1. I can either ignore 'Other Income' and assume the entire liquid cash and investments on RBL's Bank is taken at Face Value (This is a considerable value - almost Rs. 15,000 - 20,000 Crores). This is what I normally do for manufacturing and services companies.

2. Otherwise, I can let 'Other Income' be part of Net Income as it is, but ignore everything else except liquid cash (Cash in Hand and Bank) from the valuation. This way, 'Other Income' also gets projected into the future as a part of the valuation and then discounted as business cash flows.

In this case, I have chosen to do the latter. It only makes sense, because unlike manufacturing and services firms, cash is the business of a bank. Apart from extremely liquid cash kept in hand or a CASA account, every other penny is a part of parcel of the bank's operations. You will find that I have entered ~Rs. 1800 Crores worth of Cash in RBL's numbers, but ignored the investments and deposits.

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The Assumptions

Note: DCF Vs DDM

Fair warning: I am going to use a Dividend Discount Model of valuation for valuing RBL Bank. I usually use a DDM for highly leveraged institutions like banks and NBFCs. Unlike a typical DCF, a DDM is fairly straightforward. It only requires the Net Profits and a projection of Net Profits to arrive at the cash flows. This is acceptable for a bank, where there's no "Working Capital". The money earned can be considered as cash flows (Not entirely - just close enough). So, it is highly important to understand that if a DCF is only an approximate estimate of value, a DDM is an even hazier estimator.

Note: Two Stories

Remember earlier, when I said that RBL Bank can go one of two ways? Either stay with its traditional banking roots and add 'new businesses' in Credit Card, MFI and Cloud Banking as ancillaries or concentrate on growing the 'new businesses', while reduce the importance on traditional banking. Let's assume that the former is the 'Traditional+' story and the latter is the 'Unique Bank' story.

Here's what I have assumed for RBL Bank's 'Traditional+' future:

The Payout Ratio needs very little explanation. I have simply assumed that it will grow slowly over the years and settle at a fundamental estimate (Based on Terminal Period Growth and Cost of Capital).

The Cost of Capital is calculated based on the Capital Asset Pricing Model, using the Company's Beta (As calculated earlier).

So now, the Growth figures need an explanation for sure. Since we have assumed in this case that RBL Bank will still largely follow their traditional banking route, it makes sense to check how the bank's Net Profit growth has fared against its peers:

This table shows the Net Profit growth rates of RBL Bank and its peers when they had the same business size as RBL did 5 years back (i.e. Rs. 2,000 Crores). Of course, not every one of them had the same size of business in the same years, hence the indication of where the numbers have been taken for each bank. The conclusion is that RBL Bank has indeed growth a little faster than the average Indian bank (Traditional Banking bank, I might add) of the same size in history.

This leads us further to investigate how these banks have grown when they were doing RBL Bank's current size of business (i.e. Rs. 6,000 Crores):

Now, it is not too hard to conclude that RBL Bank just might grow a little faster than the average growth of 23.83% posted by its peers. RBL Bank's own estimate is proportionately calculated from the last table. So, 27.47% is assumed to be RBL Bank's Net Profit Growth CAGR for the next 5 years.

What about the 5 years after that. The data gets very sparse when you hit Rs. 20,000 Crores (Which is roughly Rs. 6,000 Crores compounded at 27.47% for 5 years). Only HDFC Bank and Kotak Mahindra Bank have grown to the size we need:

We will still take it as an approximate estimate for the 5 years after that.

Post this, it is just a convergence towards the Indian Private Banking Industry's long term average growth of ~19% and change.

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The Dividends

Based on our assumptions above, here is how RBL Bank's Net Profits and Dividends will evolve in the future:

In a graphical format, it would look like this:

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The Value

The big reveal! Here's what I think RBL Bank is worth:

Note: NPAs

I have assumed that RBL Bank can recover 40% of the NPAs that it hasn't provided for. 40% is usually the standard Recovery Rate assumed in most Credit Risk models (Even abroad), so I'm using it here too. Note, however, that I am removing the entire amount of NPAs that I have assumed RBL Bank cannot recover.

Now, obviously, the first thing you would have noticed is the large Margin of Safety that I have claimed. This is in line with my gripe that a DDM is a very, very hazy estimate of value (Even hazier than the DCF). But a bigger reason is that the finance industry is as opaque as industries could get. Nobody, not even Warren Buffett (Who is invested in several BFSI firms) understands everything that's on a bank's books (I'm not making this up - he's admitted to this on several occasions). We do get to keep tabs on the bank's NPA divergence over the years and other activities like Related Party Transactions. However, the fact that even the best Mutual Funds and Analysts in India didn't see curveballs like DHFL and Yes Bank coming, speaks a lot about what kind of caution one needs to exhibit while dealing with BFSI companies. Even more so in firms like RBL Bank, where a chunk of Revenues come from trading in securities, derivatives, forex and precious metals.

So in conclusion, with the 30% Margin of Safety (Which I declare to be quite necessary while valuing a Banking/NBFC firm), my estimate of RBL Bank's fair value is Rs. 421 a piece, indicative of a 37% overvaluation.

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The Sensitivity of Value

The 'Sensitivity of Value' tool calculates the different value ranges for RBL Bank based on varying assumptions of Terminal Cost of Equity and Terminal Growth Rates:

Not much to look at here. Let's proceed to something more interesting.

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The Monte Carlo Simulation (The 'Unique Bank' Story)

Let's now look at the story where RBL Bank focuses more on the 'new businesses', rather than depending on the traditional banking model. This will certainly bring about a few changes in our assumptions:

Net Profit Growth Rates

The management has been guiding ~30-35% Growth for the next few years, banking (Pun intended) on their newfound glory in Credit Cards and MFI. So, I will be simulating the Net Profit Growth Rate for the first 5 years between 27.47% (Our earlier estimate) and 35%. However, the Net Profit Growth Rates for the later years will remain the same. As we saw before, size does impede growth.

Payout Ratio

I will be simulating that the Payout Ratio can stay the same (15.19%) for a long time or follow our earlier estimates.

Cost of Capital

Adapting a new business model isn't all peachy. It comes with its own set of risks. With risk comes a higher Cost of Capital. However, I'm being generous in limiting the simulation of Cost of Capital between 11.20% (Our earlier estimate) and 12.82% (50th Percentile Cost of Capital for Indian companies - courtesy of Prof. Aswath Damodaran's 'Useful Data Sets').

Minority Interest and Non Performing Assets

I am also simulating Minority Interests and NPAs (Net NPA %), but this shouldn't have too much bearing on the final value. It's just a process.

This is how the initial results look like:

Put in a better way, this is the spread of values I can assign for RBL Bank:

It is difficult to derive a singular conclusion from this table, which is why I love it. Investing is all about taking risk at a personal level. And risk, believe me, changes for every single person. So, depending on how risky you think RBL is as a bank, you should pick a Probability of Undervaluation and a Value attached to it.

Being a student of Benjamin Graham and Warren Buffett, I flat out pick a Probability of Undervaluation of at least 75-90% for most of my investments. But that's just me. Like I said, you should be your own judge of RBL Bank's Value based on the interpretation above. At the CMP of ~Rs. 670, there is a ~45% Probability of Undervaluation. Is this enough? Remember, I can't answer that question for you.

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The Model

If you believe that I have made mistakes in my valuation, I'm giving you every opportunity to make it right. Feel free to download the model and modify the assumptions as you see fit:

(Download Money and the Myth - RBL Bank)

If you have suggestions or criticism about my valuation, feel free to drop a comment down below. I always encourage constructive conversations.

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Bank or Banker?

There's a saying on the street that when you invest in a Bank, you're not actually investing in the Bank, but the Banker. In other words, it is a given that Banking is a complex business and not even the best can get to the bottom of what's going on in a Bank's books. Instead, an investment should be made based on the skill, experience and ability of the CEO and his management team. After all, they are supposed to know every nook and corner of the trade. Even Warren Buffett, the Oracle of Omaha, seems to agree. So I suppose, I should ask: "Do you believe Mr. Vishwavir Ahuja and his management team will deliver RBL Bank's vision?"