# IDFC First Bank: Will it Fly?

A growth machine in competitive space

Since the merger in Dec ’18, IDFC First Bank successfully transformed its business model from legacy infrastructure and wholesale to retail lending. In this article, I will present my valuation of the bank using relative pricing and discounted cash flow methods, and compare the result with the current market price. I will begin the article with a brief review of the bank’s transformation, then with the bank valuation, and end with conclusion on my investment decisions.

**Transformation**

Within three years from the merger, the bank successfully transformed the business model from legacy accounts to retail banking. The bank impressively tilted the assets with retail deposits, became profitable, and significantly reduced legacy accounts. However, asset quality is a concern and it is largely related to stress covid-19 caused to the economy and to the sectors in it. As the virus effect eases and India drives towards growth, the asset quality is likely to improve to 2019 level. Cost of funds and provision coverage ratio (PCR) nearly unchanged from the premerger level, and but likely to reduce in the coming years largely because of the drop in interest rates to 4 percent.

The bank is in its growth business lifecycle and it is fair to assume that it will follow the traditional banks' growth path as it matures. In recent times, the bank ventured into adjacent segments in the finance sector, and within a few quarters, we are likely to witness the effects on financials. The most noticeable is the revolutionary innovation with the credit card business, offering variable rates undercutting the competitors on cost. The bank’s unique selling proposition is its customer base largely concentrated with salaried employees and micro and small entrepreneurs, labeled as unsecured by conventional banking standards. The segment is largely underserved particularly in rural demographics and IDFC First bank is placed well in capturing major market share in a decade.

# Relative Valuation (/Pricing)

IDFC First bank’s financial and market metrics are compared with its peers in the banking sector (both public and private) to predict price per share. Model the data with linear regression, statistical technique to account for the differences in the firms’ businesses. Price-to-book value is modeled with current account and saving account (CASA) as percentage of deposits, capital adequacy ratio (CAR), and market beta¹. The model has reasonably good predictive power (R² 0.683) in estimating variance in PBV value. Substituting the three variables into the expression gives predicted PBV² and then multiplying it with BV/share yields price per share of the firm. The estimated price per share of IDFC First bank is ₹92.77 and it makes that the stock trading at a 38.27 percent⁴.

PBV = -3.418 + 5.70CASA — 1.76Market beta + 35.767CAR; R² = 0.683

Before we make an investment decision, let’s review our implied biases, and without them we mostly likely estimate different prices.

- All the metrics are estimated are historical and there is no certainty that the firms will manage to sustain the growth trajectory in the future.
- Many of the firm’s metrics estimated are a quarter old.

*Note: *a: Used annual data to estimate the ratios and metrics; q: Used trailing twelve months (TTM) data to estimate the ratios and metrics; $: Private sector bank where the majority of the stake held by private corporations and individuals; #: Public sector bank where the majority of the stake held by central or state government.

**Discounted Cash Flow (DCF) Valuation**

Discounted cash flow is a valuation method used to estimate the value of an asset (or equity) based on its expected cash flows and the implied risk over time. I will begin with the model adopted in valuing the bank, then my narration that drives the assumption to estimate cash flows, and lastly finishes the valuation.

## Challenges to estimating cash flows

The major challenge of using DCF valuation to estimate the value of a bank is the complexity integrated into the banking operations. We cannot estimate reinvestment that the firm expands in growing the business because of two primary reasons. First, the dual nature of deposits that serves as raw material to earn profitability and also as debt because of the bank’s obligation to pay the interest rate and principle to the depositor. Second, the bank’s regulatory capital it holds to fund the timely liability as per RBI regulation blurs defining working capital. I have used an alternative method assuming the bank reinvests in regulatory capital alone. It enables me to estimate value using the cash flows to equity model.

## Narrations that drive valuation

In the transformation section, I have mentioned my opinion on the growth IDFC First Bank achieved since the merger and also the challenges that it is likely to face in the next couple of years largely attributed to the disruption Covid-19 has caused to the customers and economy in general. The following is my narration of IDFC First Bank’s future. Next, I will take these assumptions and translate them into financial drivers to perform the valuation.

- IDFC First Bank will continue operating in the traditional lending space targeting salaried (unsecured) accounts.
- I assume the bank will grow its assets from 1.15% total market share to 2.5% of the projected market before it becomes mature.
- I assume the bank will continue focusing on the retail segments and drive innovation and solutions to become a one-point financial solution provider.
- The bank will continue pursuing credit card business and capture a significant share of as much as 10% before it gets mature. The segment will greatly drive its profitability, however, it will increase interest rates to the industry average as it matures. I do believe that the bank will stick to the variable pricing model.
- The management claims to control risk in asset quality by maintaining gross NPA at 2% on a sustainable basis, and that puts it within the top 5-percentile in the industry.
- I assume the bank will reduce its cost to income ratio to industry median to around 50 percent in the next 5-years, largely assisted by lower interest rates on deposits that also drive profitability to the top 90th percentile of the industry.

DCF valuation of IDFC First bank with the above assumptions is shown below. The estimated value per share of the bank was ₹64.96. Performed scenario analysis with varying the key variables to investigate the effect on the bank’s estimated value per share. Asset growth rate and ROE at the end of the exceptional growth phase have a significant effect. The results of the analysis are shown below. The estimated value per share was ranging between ₹39.75 and ₹96.73 per share. In the low range case, I assume the bank will grow at a much lower rate and maintain its market share by assets at 1.15%, with 7% ROE. In the high end, the bank will become one of the top 6 leading private companies capturing 4.71% of market share in a decade, at 16.5% ROE by the end of the exceptional growth phase.

# Price/Value Comparison

We have three different numbers and which one of them reflects the true value of the bank, if not is their other value to justify the future expectations?

Relative valuation (pricing) is a statistical estimate to align the financial and market metrics with the investor expectations. The major limitation of the process is backward-looking: depends on historical data. In the DCF valuation, I tried to fix it with forward-looking estimates that aligns my narration. As the market, sector, and bank conditions changes, my narration changes and the estimated value. Among all the two estimates, I have a greater conviction on DCF valuation because the assumptions and biases I have made through the process are explicit. Moreover, to justify the price of ₹92.7 per share, the bank should capture 4.7% of the market share in year 10 with ROE exceeding 16% in 5 years. Can the bank achieve these expectations to justify the price? Theoretically, it is possible, but the likelihood is very low, particularly since the estimated price is within 99-percentile of the distribution.

**Conclusion**

The transformation of the bank to retail banking is impressive and its growth initiative leading from its penetration into the credit cards business is revolutionary. The bank experiences stress from covid-19 disrupting the customer’s lives and livelihoods and also the Indian economy. I have estimated the value per share of the bank using relative pricing and DCF methods, and both estimates indicate that the bank is trading at a discount. I have a greater conviction on the DCF value of ₹64.96, than ₹92.7 from relative pricing because it can happen only in the unlikely combination of asset growth and ROE. The estimates clearly present that the stock is undervalued and trading at a discount, however, please note that the estimates are not recommendations for your investment decisions.

**Footnotes**

- Used stepwise regression technique to eliminate other financial and market metrics.
- The model predicts 5-year growth in deposits has a statistically significant effect on PBV, however, because it has a strong correlation with CASA (0.7) so, I did not consider it to avoid signatory problems.
- The predicted market price of South Indian Bank and Punjab & Sind Bank is negative and it could be the result of the model overfitting the data, and they are removed from the rest of the analysis.
- IDFC First bank was trading at ₹57.25 per share at the end of the trading period on May 21, 2021
- The valuation model uses three-growth-phase architecture. In the first phase, the financial metrics grow at a higher rate from the current year (base year) for 5 years to the end of the extraordinary growth phase. In the second phase, the metric drops linearly for the next 5-years until it reaches a stable growth phase. In the third phase, the metrics are assumed to grow at a risk-free rate forever, at this phase we will estimate terminal value assuming the infinite life of the firm.
- The combined total assets of all the 29 banks are 14,714,544 crores. Assuming it grows at the rate of economy (risk-free rate), the total assets in year 10 is (14,714,544) x (1+4.04%)¹⁰ = 21,856,633 crores.

# What Next?

You may contradict many of my assumptions or you may have a different narration. Possibly the value resulting from your narration could be within the range estimated in the scenario analysis. I would love to read your comments and improve the model, and equally love to listen to your narration and adapt the valuation model to estimate your value. Please feel free to comment and share your narration. I hope you enjoyed reading the thesis. Please share the post with your friends and family, who you would think will benefit.

# Disclaimer

I have a vested interest in the company and that can inadvertently inscribe biased judgment along the valuation process. Please use the article for educational purposes only, which is my only intention. Don’t make any investment decisions based on the views, opinions, and estimates made in the article, and please do your due diligence before making any investment decision.