1. Equity Analysis of a Banking Company March 2008 Presented by: Asif Ali Qureshi, CFA Head of Research Invisor Securities (Private) Limited

2. 2 Sequence  Introduction  Sector Analysis  Trends in Pakistani Banking Sector  Analyzing a Bank – Concepts & Application  Building financial model of a bank  Valuation

3. 3 Introduction

4. 4 ANALYST REPORT Equity analysis is essentially a 5-part process Macro/Sector Analysis Company Analysis Financial Modeling ValuationRecommendation

5. 5 Single most important variable in valuation?  Profitability! – cash flows, dividends, etc  driven from profitability

6. 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. 7 Allied Bank – Financial Statements

8. 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. 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. 10 Sector Analysis

11. 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. 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. 13 Banking Deposit Growth vs. M2 Growth

14. 14 Beginning of an economy

15. 15 Individual sells wheat to Govt. for Rs.1,000 Individual Governmen t wheat Central Bank T-bill Cash GDP growth Fiscal Deficit

16. 16 Individual deposits Rs.1,000 in a bank

17. 17 Bank loans out Rs.800  Borrower draws down Rs.500 and leaves the remaining Rs.300 in bank account.

18. 18 Impact of $1.0 million “private” FX inflow Step-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. 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. 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. 21 Trends in Pakistani Banking Sector

22. 22 Aggregate Post-tax Profits

23. 23 Return on Equity (ROE)

24. 24 Return on Assets (ROA)

25. 25 Banking Deposit Growth CAGR: 13.2% pa

26. 26 Advances (Loans) Growth CAGR: 14.0% pa

27. 27 Higher interest rates  higher spreads

28. 28 Net NPLs as % of Net Loans

29. 29 Analyzing a Bank – Concepts & Application

30. 30 Quantitative Analysis  FINANCIAL SOUNDNESS – Profitability – Solvency  GROWTH and FUNDING MIX – Deposits – Borrowings – Loans – Investments  RISK ASSESSMENT – Credit Risk – Market Risk – Liquidity Risk

31. 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. 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. 33 Profit & Loss Statement

34. 34 Balance Sheet

35. 35 Net Profit

36. 36 Return on Assets (ROA)

37. 37 Return on Equity (ROE)

38. 38 Revenue Analysis

39. 39 Net Interest Margin (NIM)

40. 40 Non-Interest Income

41. 41 Balance Sheet Growth - Liabilities

42. 42 Balance Sheet Growth - Assets

43. 43 Loan Book

44. 44 Efficiency Ratio

45. 45 Building financial model of a bank

46. 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. 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. 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. 49 Allied Bank – Key Assumptions

50. 50 Allied Bank – P&L Statement

51. 51 Allied Bank – Balance Sheet

52. 52 Allied Bank – Output Ratio

53. 53 Valuation

54. 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. 55 Justified Price/Book Value P0P0 BV 0,1 = ROE – G R e – G G = ROE x (1 – b) P0P0 : Price at t = 0 BV 0,1 : Avg. BV for t = 0 &1 ROE: Sustainable ROE G: Sustainable growth ReRe : Equity Disc. Rate b: dividend payout ratio

56. 56 Allied Bank – Valuation based on justified P/B

57. 57 THANK YOU.