THE PSB MEGA MERGER: AN OVERVIEW

On the 30th of August, 2019, Finance Minister (FM), Nirmala Sitharam announced the merger of 10 major public sector banks (PSBs) to reduce the number of players in the banking scenario from a whopping 27 to 12. This news comes in wake of the disappointing news that India faced a 5% GDP growth in the preceding quarter. It is expected that the merger will increase the CASA (Current to Savings Account Ratio) and enhance lending capacity. These reforms were deemed necessary to foster the idea of India becoming a $5 trillion economy. Illustrated below shall be the expected scenario if the mergers are proven successful:

Merger between

Rank (based on size)

Number of Branches

Total Business Size

(Rs in lakh crore)

Punjab National Bank (A), Oriental Bank of Commerce and United Bank – Merger I

2nd

11,437

17.95 (1.5 times of current)

Canara Bank (A) and Syndicate Bank – Merger II

4th

10,342

15.2 (1.5 times of current)

Union Bank of India (A), Andhra Bank and Corporation Bank – Merger III

5th

9,609

14.59 (2 times of current)

Indian Bank (A) and Allahabad Bank – Merger IV

7th

6,104

8.08 (2 times of current)

(A) Anchor Bank

It was also announced that Rs 55,250 crore of capital infusion will take place to ease credit growth and regulatory compliance. Now we’ll look at the capital infusion expected to take place to aid the mega mergers:

Bank

Recapitalization (Rs in crore)

Punjab National Bank

16,000

Union Bank

11,700

Bank of Baroda

7,000

Canara Bank

6,500

Indian Bank

2,500

Indian Overseas Bank

3,800

Central Bank

3,300

UCO Bank

2,100

United Bank of India

1,600

Punjab and Sind Bank

750

FM also announced multifarious administrative reforms to increase accountability and remove political intermediation. Bank management is made accountable as the board will now be responsible for evaluating the performance of General Manager and Managing Director. It is mandatory to train directors for their roles thus improving leadership in the PSBs. The role of the Non-Official Director is made synonymous to that of an independent director. In order to attract talent, banks have to pay competitive remuneration to Chief Risk Officers.

The banks were merged on three criteria – the CRR should be greater than 10.875%, the CET ratio should be above 7% (which is above the Basel norms) and the NPAs should be less than 6%. However, Syndicate and Canara bank have not been able to meet the criteria.

Post consolidation facts and figures:

  • Total Business Share
  • Ratios (all amounts in %)

MERGER – I

PNB

OBC

United Bank of India

Post-Merger

CASA Ratio

42.16

29.4

51.45

40.52

PCR

61.72

56.53

51.17

59.59

CET-I

6.21

9.86

10.14

7.46

CRAR Ratio

9.73

12.73

13

10.77

Net NPA Ratio

6.55

5.93

8.67

6.61

MERGER – II

Canara Bank

Syndicate Bank

Post-Merger

CASA Ratio

29.18

32.58

30.21

PCR

41.48

48.83

44.32

CET-I

8.31

9.31

8.62

CRAR Ratio

11.90

14.23

12.63

Net NPA Ratio

5.37

6.16

5.62

MERGERIII

Union Bank

Andhra Bank

Corporation Bank

Post-Merger

CASA Ratio

36.10

31.39

31.59

33.82

PCR

58.27

68.62

66.60

63.07

CET-I

8.02

8.43

10.39

8.63

CRAR Ratio

11.78

13.69

12.30

12.39

Net NPA Ratio

6.85

5.73

5.71

6.30

MERGER – IV

Indian Bank

Allahabad Bank

Post-Merger

CASA Ratio

34.75

49.49

41.65

PCR

49.13

74.15

66.21

CET-I

10.96

9.65

10.63

CRAR Ratio

13.21

12.51

12.89

Net NPA Ratio

3.75

5.22

4.39

Advantages:

  • Economies of scale.
  • Efficiency in operation.
  • Better NPA management.
  • High lending capacity of the newly formed entities.
  • Strong national presence and global reach.
  • Risk can be spread over and thus will be minimized.
  • Lower operational cost leading to lower cost of borrowing.
  • Increased customer base, organic growth of market share and business quantum.
  • Banking practices reform announced to boost accountability and professionalism.
  • Appointment of CRO (Chief Risk Officer) to enhance management effectiveness.
  • Centralized functioning promoting a central database of customers.

Disadvantages:

  • The slowdown witnessed by the economy coupled with the dangerously low demand in the automobile sector will maintain the existing situation pessimism.
  • The already existing exposure of NBFCs in the individual constituent banks will be magnified as the merged entities shall have more than 10% loan exposure to NBFCs and thus, in effect, the liquidity pressure that comes along with it.
  • As history dictates, the merger of these eminent banks will cause near-term problems with respect to restructuring, recapitalization, operation, flexibility and costs.
  • Near-term growth shall be hindered and core profitability may suffer.
  • Compliance becomes a huge barrier.
  • Difficult to merge human resources and their respective work cultures post-merger – this will in turn lead to low morale and inefficient workforce

Outlook:

The mergers were announced with a very noble idea in mind; however, the timing is a bit unfortunate. During these times of economic slowdown, India needs its bankers devoting their time to boost the economy. With the merger happening, the banks will be more pre-occupied with the integration process rather than enhancing the economic growth. Merely combining banks will not help enhance credit capacity, it is also important to see whether synergies in reality will be created (or if it is merely on paper).

The share of assets of the top three or four banks account for only 30%-32%. Thus, the banks still remain fragmented for a major part – systemic risk or contagion effect shall not be a problem as of now. Although this is the case, out of the four mergers not one of them can be said to be financially strong. This is a phenomenon of blind leading the blind; it cannot be expected that two financially weak banks can merge into one financially strong entity. “A chain is only as strong as its weakest link.”

This announcement comes at a time when even the results of the previous mergers (e.g. Bank of Baroda) have not yielded any fruit and the PSBs have recently jumped back from a long stress scenario. It seems as if there is no common theme in the mergers (i.e. retail, corporate or SME), no particular skill-set that has been emphasized upon. Rather, it was just assumed that all the banks fall under the same template and a haphazard combination was made – in such a case, there is a slim chance of synergy creation. Also, with no major theme in hand the multifarious objectives will confuse the banks with respect to the pressing matters at hand.

According to technical experts, it might take around three to four years to integrate the existing IT systems of the banks. Although all of the use the CBS, heavy customization is required, mobile apps need to be in sync, backend functions have to be centralized effectively.

As for the case of resolution of NPAs, it might actually become easier and faster. Earlier, the bankers had to talk to their counterparts, the approach the senior management to come to a resolution. Now, with these institutions merging and with lesser levels to report to, a solution plan can be implemented at the earliest with considerably less effort. Apart from this, now that the banks will have a common database and a larger network, they can increase the services offered at a higher level at lower costs – this might show an increment in the fees earned and in turn, the profitability. It is expected that the Anchor banks will be benefitted more from the mergers as the swap ratio will be in their favour.

Author
Chandreyee Sengupta
Team Member- Equity Research & Valuation
(MSc Finance, NMIMS Mumbai. Batch 2019-21)

Connect with Chandreyee on LinkedIn
Advertisements

Valuation methods and issues that arise while conducting valuation

Valuation of a Business is conducted in order to arrive at an estimation of the Economic Value of an Owner’s Interest in a certain Business under the guidance of a certain set procedures. Valuation may be computed for a business in order to arrive at an accurate snapshot of the Financial Standing of the business which is presented to Current or Potential Investors. Valuation is generally conducted when a company is looking to merge with another company or acquire another company or sell off the entire or a fragment of its operations to another company. Some other reasons to conduct Valuation include establishing partner ownership, taxation, analysing the financial strength of the business i.e. determining solvency, planning for future growth and profitability of the business or even divorce proceedings. Further is a brief description of the approaches to Valuation Models and the issues that arise when conducting Valuation under those methods.

There are Three Different Approaches which are commonly used in Valuation:

  1. Income Approach
  2. Asset Based Approach
  3. Market Approach

Further is a brief description of the approaches to Valuation Models and the issues that arise when conducting Valuation under those methods.

I. INCOME APPROACH

  • Under the Income Approach, Valuation is based on the Economic Benefit expected from the investment and the level of risk associated with the investment.
  • There are several different Income Methods which include Capitalisation of cash flow or earnings, Discounted Future Cash Flows which is commonly known as DCF and the excess earnings method.
  • DCF is the Net Present Values of the Cash Flows projected by the company. The Value of an asset is intrinsically based on its ability to generate Cash Flows is the underlying principle of this approach.
  • This method relies more on the fundamental forthcoming expectations of the business rather than on the public market factors.

ISSUES THAT ARISE WHEN CONDUCTING VALUATION USING INCOME APPROACH:

1. USING ACCOUNTING PROFITS INSTEAD OF CASH FLOW

  • The value of a business depends largely on the profitability, financial health and earning power. Accounting Profits and Cash flows are two means to measure it.
  • Free cash flow is a better means to analyse profitability as compared to accounting profit because the Revenues and expenditures of the business are accounted for at the right time and the cash flows of a business cannot be manipulated as much as earnings.

2. OVERLY OPTIMISTIC REVENUE FORECASTS

  • At times while projecting the forecasts, the revenue is shown to be shooting up in numbers during the forecast period. This results when taking a hypothetical high growth rate.
  • What the valuer fails to notice is whether the growth of the company is aligned with the industry, what the market size of the company is or even whether the company has a strategy to achieve the desired growth goal.

3. NARROW FORECAST HORIZON

  • What should be taken as the optimal length of the Financial Forecasts is one of the key choices that need to be made.
  • If a shorter forecast period is considered, it fails to give the effect of different parameters on the business in the upcoming years. For example in case of a company under FMCG sector, it would not be right to prepare financial forecasting for a period of just two to three years.
  • On the other hand is the length considered is too long, the valuation could result as misleading. This is because in the long run, risks associated with the business cannot be anticipated easily.
  • Thus, it is essential to consider an explicit time frame while conducting valuation that is neither too short nor too long. A time frame ranging from 5 to 7 years is generally considered when performing DCF Valuation.

4. INCORRECT BETA

  • Beta comes into consideration when deriving the Cost of Equity of a company.
  • When Valuation of a company is done under the circumstances of a merger or an acquisition, majority of the times, the Beta is taken to be that of the Acquiring Company. This is done under the assumption that the Target Company is a smaller company when compared to its bidder, thus the Target Company would have no influence on the resulting Capital Structure as well as the riskiness of the New Company.
  • Other times, the Beta considered is an estimation of the emerging company’s Beta with respect to a Market Index. But just using the historical beta is very risky when the company or its future risk prospects are not analysed.
  • At times, when levering and unlevering the Beta to arrive at the estimate, incorrect formulae are used. The levering should depend on the amount of debt prospect of the company in future.

5. HIGH COST OF EQUITY

  • Along with Beta, another problem that arises in deriving the Cost of Equity is the Risk free Rate.
  • Majority of the times the Risk free rate considered is just the 10 year Government Bond Yield.
  • What one fails to consider in this is the Country Risk. If this view is taken into consideration, the Cost of Equity of a company in United States would be same as that of a company in Bolovia, which is highly incorrect.
  • Thus, the Country Risk Premium needs to be deducted to arrive at an accurate Risk Free Rate.

6. INCORRECT DISCOUNT RATES

  • It is a wrong notion to consider a higher discount rate when there are higher risk cash flows, on the basis that the discount rate on cash flows should reflect the riskiness.
  • Generally Book Values of Debt and Equity for arriving at the Weighted Average Cost of Capital (WACC). But this violates the Basic Principle of Valuation which is to arrive at a Fair Value
  • Thus, when valuing an on-going business, the market values of debt and equity should be taken into consideration to derive the WACC.

7. HIGH LONG TERM GROWTH RATE

  • There is a Material Impact created on the value of a company when a long term growth rate is used.
  • This is considered when arriving at the Terminal Value. The Terminal Value is the Present Value of all the Cash Flows at a future point in time, when the cash flows are expected to be at a stable growth rate.
  • These Long Term growth rates generally lie in the range of 5% to 6%.
  • They depend on the growth rate of the economy and never exceed that figure. This is because, a higher growth rate than the GDP rate of the economy would imply that the company would grow larger than the economy. Applying such a high rate would result in overvaluation.

II ASSET BASED APPROACH

  • Under this approach, the value of a business is derived as a sum of its parts. This method takes into account all the assets and liabilities of the Business.
  • The Value of the Business is the difference between value of all relevant assets of the business and value of all the relevant liabilities.

III MARKET APPROACH

  • This approach is used to derive the appraisal value of the business, intangible asset, security or business ownership interest by considering market prices of comparables which have been sold recently or are still available.
  • There are two main Valuation Methods under this approach-
    1. Comparable Companies Method – This method entails the use of valuation multiples of companies which are traded publically.
    2. Comparable Transactions Method – This method entails the use of valuation figures of observed transactions of companies in the same industry as that of the Target Company.
  • Certain common multiples considered for Relative Valuation are – P/E Ratio, PEG Ratio, EV/Sales, EV/EBITDA, EV/ Sales.

ISSUES THAT ARISE WHEN CONDUCTING VALUATION USING MARKET APPROACH:

1. INCORRECT PEER SELECTION

  • The industries in a market are often loosely defined. Making is difficult to select optimum peers to conduct Comparable Company Analysis.
  • Some of the major factors to be considered while selecting peers are product line, geography, seasonality, revenue, etc.
  • Another way to identify peers it to check the annual report of the companies, in case the company is a listed one, where the peers would be mentioned.
  • The same could apply for a Comparable Transaction Analysis. Where Multiples of an extra ordinary Transaction are considered for conducting Valuation.

2. INCORRECT MULTIPLES

  • There are a number of Multiples available to value the worth of a business. Each of these Multiples relate to a specific extent of the financial performance to the potential selling price of the business.
  • If a multiple is based on the Net Cash Flow, it should not be applied to the Net Profit.
  • For valuing new companies, which have small sale and negative profits, using multiples such as Price-to-Sales or Enterprise Value to EBITDA Multiples can be misleading. In such cases, Non-Financial Multiples can be helpful.
  • Certain common multiples considered for Relative Valuation are – P/E Ratio, PEG Ratio, EV/Sales, EV/EBITDA, EV/ Sales.

3. NOT ADJUSTING THE ENTERPRISE VALUE TO EBITDA MULTIPLE FOR NON-OPERATING ITEMS

  • The Enterprise Value should not include excess cash. Also the Non-Operating Assets must be evaluated separately.
  • Operating leases must be considered in the Enterprise Value, the interests costs associated to such operating leases must also be added back to the EBITDA Value.
  • This is because though the Value of Lease and the Interest Cost of the lease, affect the ratio in the same direction, the effect is not of the same magnitude.

4. TAKING AVERAGE INSTEAD OF MEDIAN

  • While conducting Relative Valuation, it is a common practice to consider the Average value of the PEER’s multiples instead of Median value.
  • The middle element of the data is the Median Value. Taking Median Value enables the extremely high or low values to be disregarded.

5. USING RELATIVE VALUATION AS PRIMARY VALUATION METHODOLOGY

  • Valuation should not be derived by depending on just one methodology, especially just Relative Valuation. Relative Valuation is a considerably good method to validate the value derived from other Valuation Methods.
  • One issue of relying on Relative Valuation is that getting data of a privately owned business is difficult. Also the shares of a public company are more liquid than that of a private company.

CERTAIN OTHER COMMON ISSUES THAT ARISE WHEN CONDUCTING VALUATION:

1. CONSIDERING VALUATION IS A SCIENTIFIC FACT

  • Most of the times it is asserted that Valuation is a Scientific Fact rather than an Opinion.
  • A logical process is followed to reach a Valuation Figure or Opinion, thus there is the role of Science.
  • But what is forgotten is that the Value arrived at from any Valuation Method, is contingent to a set of assumptions and expectations. These expectations include future prospects of the company, industry or even the country. Another thing which is factored in is the Valuer’s appraisal of Company Risk.
  • Hence, valuation is more of an Art than a Science.

2. ASSUMING THAT EVERY ESTABLISHED BUSINESS HAS A POSITIVE GOODWILL

  • Business Goodwill is actually directly related to the earning power of the business.
  • If the Business earnings fall below the return on assets, then the business has a negative goodwill.

3. FAILING TO ASSESS COMPANY SPECIFIC RISK

  • When conducting Business Valuation, risk assessment plays a very important role.
  • Each company has different financial and operational factors which contribute to its risk profile.
  • Thus, each company has different Discount and Capitalisation rates which need to be taken into consideration.

4. REDUNTANT ASSETS ARE NOT ADDED TO COMPANY VALUE

  • Redundant assets are those which are not required for the day to day operations of the business. The value of such assets should be added to the value of the business or company.

5. THINKING THAT THE BUSINESS PURCHASE PRICE AND PROJECT COST ARE THE SAME

  • Many a times the project cost is considered to be the same as the purchase price. But that is not correct.
  • In order to arrive at the Purchase price s=certain adjustments need to be made to the project cost.
  • One such adjustment is that the buyer of the business also needs to inject certain working capital.
  • If there is any deferred equipment, its maintenance cost also needs to be adjusted.
  • There are certain investments which are needed to maintain the income stream such as hiring staff replacements, licences, regulatory compliances, etc. Such costs also need to be adjusted.

The method which has the capability to incorporate all the significant factors which have a material effect on the Fair Value is the Most Appropriate Method of Valuation.

Furthermore, one must keep in mind the above issues which can arise while deriving Valuation for a Business, Stock or Company in order to avoid any misleading valuation figures.

Author
Vhabiz Lala
Volunteer – Equity Research & Valuation (M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

Connect with Vhahbiz on LinkedIn