# How To Calculate The Intrinsic Value Of A Bank: Case Study – HDFC Bank

This post contains a method of calculating the intrinsic value of a bank. Intrinsic value is a fuzzy concept and can have different values depending on what inputs you put in and who calculates it. I like this method. But do not follow me blindly. Make your own judgment. All of the following may be wrong.

How does a bank make money?

The best funding source for banks is deposits. The bank pays a rate of interest for your deposits. It then uses the money you give them and lend them to others. The rate at which they lend the money is higher than the rate they pay you for your deposits. They make money on the difference between the lending rate and the deposit rate. So if a bank can gather deposits cheaply, they can make a lot of money even if they lend conservatively.

Today, I am going to try to value HDFC Bank based on its deposits and loans. This is inspired by Geoff Gannon’s article on how to calculate the intrinsic value of a bank. Read this article also. Look at these two documents:

The basic principle is:

Intrinsic value of a share = Pre- tax deposit earning power  x 10( 10 is like a P/E ratio for pre-tax earnings which is approximately equal to P/E ratio of 15 for after-tax earnings)

Pre-tax deposit earning power = Value of deposits per share x ( rate of lending – rate of borrowing)

CALCULATION FOR RATE AT WHICH HDFC BANK IS LENDING MONEY

• Average loans( Advances)327272.79 + 303000.27 = 315136.53 crores
• Interest income( Interest earned): 44446.95 crores
• ### Rate at which HDFC bank is lending money = Interest income/average loans x 100 = 14.1%

CALCULATION FOR RATE AT WHICH HDFC BANK IS BORROWING MONEY

• Average deposits(Deposits): 390681.75 +  367337.48 = 379009.615 crores
• Interest paid on deposits( Interest expended)24176.94 crores
• ### Interest rate that HDFC bank gives for its deposits = Interest expended/ average deposits x 100=6.38%

• Other income: 8047.36 crores
• Operating expenses: 12746.10 crores
• Net expenses of HDFC bank to gather deposits: Operating expenses – other income = 4698.74 crores

• ### Total cost on deposits = Interest rate that HDFC bank gives for deposits + Cost to gather deposits = 6.38% +1.24%= 7.62%

CALCULATION OF VALUE OF DEPOSIT PER SHARE FOR HDFC BANK

• Total number of shares of HDFC bank = 2414322155
• Value of deposit per share =  Average deposits/ Number of shares = Rs. 1569.83

CALCULATION OF PRE-TAX DEPOSIT EARNING POWER OF HDFC BANK

BASED ON CORPORATE BOND YIELDS(this assumes HDFC bank borrows at corporate bond yields, which was 8.63% on 29/12/2014)

• Pretax deposit earning power( based on corporate bond yields) = Value of deposit per share x ( Corporate bond yield-Cost of deposits) = 1569.83 x(8.63-7.62)/100= 15.85

BASED ON ACTUAL LENDING AND DEPOSIT RATES

• Pretax deposit earning power( based on actual lending and deposit rates) = Value of deposit per share x( lending rate – deposit rate) =1569.83 x (14.1-7.62)/100= 101.72

CALCULATION OF INTRINSIC VALUE OF HDFC BANK

• Intrinsic value( based on corporate bond yields) =15.85 x 10 = Rs. 158.5
• Intrinsic value( based on actual lending and deposit rates) = 101.72 x10 = Rs 1017( may be more realistic valuation, but you have to allow for losses)

Market share price of HDFC bank on 29/12/2014 =Rs. 954.55
Intrinsic value of HDFC bank ( based on actual lending/deposit rates) on 29/12/2014 =Rs. 1017

## 5 thoughts on “How To Calculate The Intrinsic Value Of A Bank: Case Study – HDFC Bank”

1. MGS says:

The article was very good.It made me think about the fair value of a bank. But interest earned denotes the interest earned on fund parked with RBI and other sources as well. So Assuming that the entire interest is from advances leads us to an inflated lending rate. The Net interest Margin of HDFC is hovering around 4%. So wont the fair value of HDFC Bank with regards to lending lead us to 0.04 *(total deposits). Kindly correct me if I am Wrong

• Venkata Sreekanth Sampath says:

Thank you.
The interest earned from RBI and other sources is very small. The bulk is interest from advances and income from investments which is also clumped together with interest income. Yes, in a purist sense, what you say is true. However what we should be interested in is what HDFC bank is able to earn both from advances as well as investments which they likely have made using the deposits they get or using the deposits as security. This will likely give us the true earning power rather than the net interest margin alone, in which case the valuation will be conservative, around 600-700 per share, I think. So that is why intrinsic value is a fuzzy concept and there can be a range depending on the person who is doing the calculation.

2. MGS says:

Thanks a lot for the patient and quick reply.In smaller banks like Karur Vyasa the difference was significant so got that doubt.How can we evaluate the value incorporating NPA as well. What I thought was (Net NPA in rs)*(Rate of lending) will give the interest amount the npa would have generated.if it had been a standard asset. Subtracting that lost interest from the interest earned in the calculations might give a better picture. I have lot of other doubts which i propose to ask you in the replies.

• Venkata Sreekanth Sampath says:

It is very difficult to value banks which have a lot of NPAs, because, the future becomes very unpredictable. Yes, at a certain price, they would be cheap and you may be able to sell them later at a profit but cannot hold long term. In such cases, I want the stock to be trading at a 2-5 year low and the stock price should be 50% of ( Book value+ 10 times the most recent annual dividend); basically valuing the stock like a bond.

3. vimal says:

By using the above calculation I found the intrinsic value of sbi is 1308 and how would trading at huge difference in price. pls reply me