Equity Analysis of a Banking Company

March 2008

Presented by:

Asif Ali Qureshi, CFAHead of ResearchInvisor Securities (Private) Limited

2

Sequence

Introduction

Sector Analysis

Trends in Pakistani Banking Sector

Analyzing a Bank – Concepts & Application

Building financial model of a bank

Valuation

3

Introduction

4

ANALYST REPORT

Equity analysis is essentially a 5-part process

Macro/Sector Analysis

Company Analysis

Financial Modeling

Valuation

Recommendation

5

Single most important variable in valuation?

Profitability!

– cash flows, dividends, etc driven from profitability

6

Profitability is essentially a function of…

Volume

– Quantity sold for an industrial enterprise

– Asset size in case of a banking company

Profit Margins

– Spreads or Net Interest Margin in case of banking company

7

Allied Bank – Financial Statements

8

Bank’s P&L is closely tied with its Bal. Sheet

Size (Volume) is related to:

– Earning Assets = Advance, Investments, FI Lending, etc.

– Interest Bearing Liabilities = Deposits, Borrowing, etc.

Net Interest Margin (NIM) is a function of:

– Earning Asset Mix, Deposit Mix, Interest Rates, etc.

Other factors influencing profitability

– Non-Interest Income (Fee income, Dividends, etc.)

– Non-Performing Loans (NPLs)

– Operating Efficiencies (i.e., Admin Cost)

9

Factors affecting a bank’s balance sheet/P&L

Sector Related

– Need for sector analysis!

– Extends beyond cross-sectional and time-series analysis

– Macro factors exert major influence

Bank Specific

– Understanding bank’s strategy and competitive strengths and

how they translate into profitability.

10

Sector Analysis

11

Sector Analysis

Macro-Economy

Regulatory Regime

Capital Market Development

Global and Regional Trends

Cross-sectional & Time Series Comparisons (Ratio Analysis)

Develop sector outlook

Identify key attributes of

relatively superior

banking strategy.

12

Macro-Economic Factors

Being an integral part of an economic system, the

banking sector is more sensitive (than most other

sector) to changes in macro-economic factors such as:

– Growth & Inflation

– Monetary Policy

– Fiscal Policy

– External Account

Understanding the mechanics of linkages between

macroeconomic factors and the banking sector is

therefore extremely important.

13

Banking Deposit Growth vs. M2 Growth

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

Banking Sector Deposit Growth M2 Growth

14

Beginning of an economy

15

Individual sells wheat to Govt. for Rs.1,000

Individual Government

wheatCentral Bank

T-bill

CashCash

GDP growth Fiscal Deficit

16

Individual deposits Rs.1,000 in a bank

17

Bank loans out Rs.800

Borrower draws down Rs.500 and leaves the remaining

Rs.300 in bank account.

18

Impact of $1.0 million “private” FX inflowStep-1: $1.0 million remittance received through Bank.

Step-2: Bank sells US$ to SBP, which credits Rs.60 million to the Bank’s

account with SBP SBP’s NFA increases by $1.0 million.

Step-3: Bank in turn credits the account of recipient of remittance by

Rs.60 million.

19

Examples: Impact on Banking Sector

ECONOMIC GROWTH

– Higher GDP Growth Higher M2 Growth Faster expansion

in banks’ balance sheets

EXTERNAL ACCOUNT

– Large “private” FX inflows More PKR Liquidity Higher

deposit growth

MONETARY POLICY

– Tightening Slower credit demand Slower M2 growth

Slower growth in banks’ balance sheets. ↑ SPREADS

FISCAL DEFICIT

– Higher monetization More Liquidity Higher deposit growth

20

Regulatory Factors & Capital Market

MAJOR REGULATORY CHANGES

– Min Capital of PKR6.0 billion by Dec 2009 Consolidation

– Implementation of Basel-II from 2008 investment in internal

control systems, credit rating culture, increased risk/exposure

consciousness, etc.

CAPITAL MARKET DEVELOPMENT

– Banking Sector and Capital Markets are, in many cases,

alternative channels of intermediation: Mutual Funds and

Bond Market slower intermediation through banking channel.

– NSS reforms have so far helped banking sector more than

developing the capital market.

21

Trends in Pakistani Banking Sector

22

Aggregate Post-tax Profits

-20

-10

0

10

20

30

40

50

60

70

80

90

1001

99

7

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

PKR Billion

23

Return on Equity (ROE)

-40%

-30%

-20%

-10%

0%

10%

20%

30%1

99

7

199

8

199

9

200

0

200

1

200

2

200

3

200

4

200

5

200

6

200

7

24

Return on Assets (ROA)

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%1

99

7

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

25

0.0%

4.0%

8.0%

12.0%

16.0%

20.0%

24.0%

28.0%

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

Banking Deposit Growth

CAGR: 13.2% pa

26

Advances (Loans) Growth

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

CAGR: 14.0% pa

27

Higher interest rates higher spreads

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%1

99

7

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

Lending-Deposit Rate Spread T-bill Yield

28

Net NPLs as % of Net Loans

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%1

99

7

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

29

Analyzing a Bank – Concepts & Application

30

Quantitative Analysis

FINANCIAL SOUNDNESS

– Profitability

– Solvency

GROWTH and FUNDING MIX

– Deposits

– Borrowings

– Loans

– Investments

RISK ASSESSMENT

– Credit Risk

– Market Risk

– Liquidity Risk

31

Risk Assessment

CREDIT RISK

– Concentration in fewer sectors.

– How much of banks’ lending is to pro-cyclical sectors.

LIQUIDITY RISK

– GAP Analysis: Difference between a bank’s liabilities and

assets as both mature over time.

MARKET RISK

– Exposure to equities, derivatives and bonds.

32

Non-Quantitative Factors

Ownership

Market Positioning & Strategy

Product Mix & Delivery Channels

Human Resource Quality

Internal Control Systems

IT Platform (Core Banking Solution, ATM Network, On-

line networks, Internet banking, etc. )

Investor Relations

33

Profit & Loss Statement

34

Balance Sheet

35

Net Profit

-1.5

0.40.2

3.0

4.44.1

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

200

2

200

3

200

4

200

5

200

6

200

7

PKR Billion

36

Return on Assets (ROA)

-1.4%

0.3%0.1%

1.8%2.0%

1.4%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

2002

2003

2004

2005

2006

2007

37

Return on Equity (ROE)

-10.3%

6.1%

26.0%28.6%

21.7%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

20

02

20

03

20

04

20

05

20

06

20

07

38

Revenue Analysis

39

Net Interest Margin (NIM)

40

Non-Interest Income

41

Balance Sheet Growth - Liabilities

42

Balance Sheet Growth - Assets

43

Loan Book

44

Efficiency Ratio

45

Building financial model of a bank

46

Key Assumptions – Macro/Sector

Translate economic/sector analysis in forecasts for:

– M2 growth

– Interest rates

– Deposit growth

– Advances growth

Sources of economic forecasts

– Multilaterals: IMF/WB/ADB

– State Bank of Pakistan

– Consensus forecasts maintained by data services such as

Reuters, Bloomberg, etc.

47

Key Assumptions – Bank Specific

Balance Sheet – Develop forecasts for:

– Deposit Growth

– Deposit Mix

– Borrowing

– Advances Growth

– Non-Performing Loans (NPLs)

– Investment Portfolio Mix

– Cash/FI lending

Net Interest Margin (NIM) – Forecast based on:

– Interest Yield = f (interest rates, portfolio mix)

– Cost of Funds = f (interest rates, deposit/borrowing mix)

48

Key Assumptions – Bank Specific

Non-Interest Income

– Fee income = f (trade, guarantees, advisory, etc)

– FX income = f (exchange rate, trade, remittances)

– Dividend/Capital Gains = f (equity portfolio)

NPL provisioning

– NPL charge = f (credit risk)

Administrative Cost

Taxation Rate (35%)

49

Allied Bank – Key Assumptions

50

Allied Bank – P&L Statement

51

Allied Bank – Balance Sheet

52

Allied Bank – Output Ratio

53

Valuation

54

Key approaches to bank’s valuation

Distributable Dividend Model

Price/Book Valuation

– Time series and/or cross-sectional comparisons.

– Justified P/BV multiple: [ROE – Growth] / [Re – Growth]

Price/Earnings Multiple

– Time series and/or cross-sectional comparisons.

Market Cap/Deposits

– Adjusted for NIM, it is a measure of Franchise Value.

55

Justified Price/Book Value

P0

BV0,1

=ROE – G

Re – G

G = ROE x (1 – b)

P0 : Price at t = 0

BV0,1 : Avg. BV for t = 0 &1

ROE : Sustainable ROE

G : Sustainable growth

Re : Equity Disc. Rate

b : dividend payout ratio

56

Allied Bank – Valuation based on justified P/B

57

THANK YOU.