Private banks in demand despite higher valuations

Print Friendly

Stocks of prominent private sector banks like HDFC Bank, IndusInd Bank, Axis Bank, Kotak Mahindra Bankand YES Bank are trading at valuations two-five times their 2016-17 estimated book value. These valuations are much ahead of their public sector counterparts, which are trading at 1 time 2016-17 estimated book value or even lower. Despite this, the street prefers private sector bank stocks over those from the PSU (public sector undertaking) space.

For one, private banks enjoy relatively stronger asset quality and provision coverage ratios. Over the years they have garnered additional market share from PSU banksas well as improved their profitability. Their pre-provision profits are healthy and can accommodate further increase in credit costs, if the situation arises.

Pre-provision profits consist of net interest income and fee income minus operating expenses and reflect the operational strength of a bank. Thanks to healthy pre-provision profits, return on equity (RoE) ratios of most private banks are pegged at 12-20 per cent for 2016-17, even after factoring in some increase in credit costs.

It is due to these reasons private banks are commanding premium valuations and are among preferred picks in the banking space.

Anil Agarwal, managing director and head of Asian Financial Research, Morgan Stanley, in an interview to Business Standard on June 1, said, “Globally, financials are not generating much growth and are struggling to achieve RoEs of six-seven per cent. In India, private banks are growing revenues at 20-25 per cent annually and will keep growing at these levels in the next five years. The compounding effect here is huge.”

Further, given their well-capitalised balance sheet, private banks are poised to tap growth opportunities arising from an economic recovery. In fact, some macroeconomic indicators are already indicating a recovery.

Private banks in demand despite higher valuations

On the other hand, many public sector banks not only have huge bad loans to cope with, but are also facing a dearth of capital to fund future growth. As a result, PSU banks are expected to continue losing market share to both private players as well as new entrants.

“As PSU banks remain constrained for capital, private banks’ market share gains are accelerating,” says Ashish Gupta, financials analyst at Credit Suisse. HDFC Bank, IndusInd Bank,and ICICI Bank are his top picks in the sector.

Within private banks, those focused on the retail segment such as and have been most resilient to asset quality shocks so far. Gross non-performing assets (NPAs) formed a little less than 1 per cent of each of these banks’ loan books in 2015-16.

Corporate-focussed banks such as ICICI Bank and Axis Bank have witnessed relatively higher asset quality stress. While ICICI has kept 4.8 per cent of its loans under watch, this metric stands at 6.7 per cent for Axis Bank. The healthy profitability as well as return ratios though provide a cushion to accommodate higher stress, believe analysts. YES Bank has a negligible watch list and has also done fairly well so far.

Ajay Bodke, chief executive officer and chief portfolio manager, at Prabhudas Lilladher, said, “My portfolio construct would make a larger allocation towards retail-focused private banks and some to corporate-focused private banks. For instance, HDFC Bank, IndusInd Bank would get the largest allocation followed by YES Bank.”

For many PSU banks, the impairment of balance sheet was so severe that a massive injection of capital from the government was the only salvation, he added.

Though the valuation premium is likely to sustain, on a one-year forward price-to-book value basis, most private banks are trading lower than their peak valuation levels. Long-term investors can hence consider them.

Dipen Shah, head of research, Kotak Securities, said, “Although private sector banks are trading at relatively higher valuations, we would not shy away from them just because valuations are high. The valuations are much lower than their historically peaks.”

Previous articleMarginal gain in banks’ Tier-I capital from Reserve Bank’s easing
Next articleBhageeratha Engineering Ltd Ernakulam
Tax Origin is a bunch of enthusiastic Chartered Accountants and Software Professionals, rendering services in the field of Web Application Development, with a distinct focus on Accounting, Taxation and Enterprise integration E-commerce Solutions. The Company can be reached at