Case Analysis

Vision
24(3) 376–378, 2020
Case Analysis I: City Union Bank— © 2020 MDI
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Residual Income Approach to Valuation in.sagepub.com/journals-permissions-india
DOI: 10.1177/0972262920953751
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Ullas Rao1

This is very interesting and could not have come at a more The spate of distressed signals sent by public sector banks
opportune time. An essential prerequisite of a good case in general is a testament to this fact. In that sense, it is
analysis rests on the ability of the case reader to discuss useful to argue three distinctive attributes supporting the
multifaceted issues and derive lessons by looking at the bank’s growth momentum—regional exposure, size and
case problem in its entirety. Consequently, the analysis of strategic sectoral focus. Even as India reels under a wider
the case is divided as follows. First, there is a general dis- economic slowdown, magnification of economic woes is
cussion surrounding the macro environment within which relatively tempered in the southern part. Partly owing to
the banks need to function and, therefore, bear the brunt better Human Development Index (HDI) indicators along
directly or indirectly. It follows with a discussion surround- with skilled manpower and disposable incomes imply that
ing the business and financial indicators presented in the smaller banks focused on the southern belt are relatively
exhibits and constructing the emergent thoughts with the better insulated from the volatile business sentiments impa-
larger issue surrounding the performance of the bank cting their bigger counterparts predominantly exposed to
within the prevailing business environment. And lastly, the non-southern geographies. As highlighted earlier, City
analysis critically looks at the most suitable approach to Union Banks is able to clearly reap rich dividends from its
valuation best suited to determine the intrinsic value of the lack of exposure to big business conglomerates as well as
City Union Bank. the infrastructure sector.

The Big Picture! Making Sense of the Business and

At a time when the banking sector in India is undergoing Financial Exhibits
tectonic shifts, be it in terms of exposure to stressed assets As a go-to bank for retail customers particularly in the rural
or the underlying wave of consolidation, City Union Bank areas, City Union Banks has achieved an impressive
represents a rare example as an efficiently run bank among growth in enhancing the number of banking outlets from
the smaller banks, and thereby standing out of the crowd. 268,454 in 2013 to 598,093 in 2017 registering a com-
With its headquarters located in the pristine temple town of pounded annual growth rate (CAGR) of 22.17 per cent.
Kumbakonam in Tamil Nadu, India, the bank always has Augmenting the steady expansion of the retail bank branch
maintained a steady momentum by remaining focused on network, the bank also witnessed a healthy growth in the
non-infrastructure sectors to augment loan growth. It is number of ATMs, which increased from 114,014 in 2013 to
evident from the case that the bank maintains a conserva- 208,354 in 2017 clocking a CAGR of 16.27 per cent.
tive loan exposure with 76 per cent of the loan book coming An efficiently run bank calls for a competitive cost of
from agricultural; micro, small and medium enterprises funds. And this is where deposits play an important role in
(MSME); trade services; and gold loans. The strategy achieving the above objective. Given the detrimental
adopted by City Union Bank has significant implications. implications of external borrowings on banks’ cost of
Combined with the effect of global headwinds teetering capital, banks are well advised to shore up their deposits.
towards a possible ‘recession’ and domestic economic Not just from the standpoint of cost of securing current
woes as a result of slowing growth, infrastructure remains account and savings account (CASA), deposits present
one of the most vulnerable sectors of the Indian economy. fewer dangers as opposed to risks arising from a volatile

1 Department of Accountancy, Economics and Finance, Edinburgh Business School, Heriot-Watt University, Dubai Campus, Dubai, UAE.

Corresponding author:
Ullas Rao, Department of Accountancy, Economics and Finance, Edinburgh Business School, Heriot-Watt University, Dubai Campus, Dubai Knowledge
Park, P.O. Box 38103, Dubai, UAE.
E-mail: u.rao@hw.ac.uk
Rao 377

interest environment evident in external borrowings. To Ke (Cost of equity as in CAPM) = Rf + βi (Rm­ – Rf).
that extent, it is interesting to note that the City Union Bank
registered an impressive CAGR of 10.59 per cent in total where
deposits. In terms of loan and advances, the bank witnessed
Rf = 
Risk-free rate of interest represented by long-tern
a moderately healthy CAGR of 8.39 per cent. The above
Govt bond
trends are well reflected in the increase in net profit for the
Rm = Return on market index
bank which increased from `322.03 crore in 2013 to
βi = Measure of systematic risk.
`502.77 crore in 2017 registering a CAGR of 11.78 per
cent. In the discounted version, the intrinsic valuation
Looking at the stock price performance, it is evident assumes the following form:
that the stock has clearly been a darling of the market
evidenced by its impressive growth from approximately Rt Rt + 1
V0 = BV0 + >{ H +> H (2)
n
1
tx
`50 in 2013 to `140 in 2017 registering a CAGR of 29.36 _1 + K ei _1+ K ei _K e - g ni
t
t=0
per cent. With an estimated beta value at 1.24, the stock is
observed to be only moderately riskier in comparison to where
the market.
BV0 = Book value in the current year

The Final Analysis: Valuation gn = growth rate in the terminal year.

As in the art, it is best to describe valuation in a single Readers familiar with conventional discounted cash flow
statement—value lies in the eye of the valuator! Valuation techniques will be able to appreciate the above function
is at best an imprecise exercise and invariably imposes effortlessly.1 Therefore, without revisiting the above intri-
some degree of ‘moral hazard’ on the valuator as the latter cacies, the application of residual income approach in City
is constantly toying with the inputs until she reconciles the Union Bank is presented as follows:
intrinsic value closest to the market value. To that extent,
Book value for City Union Bank for 2017 (in crore
valuation thus represents an interesting amalgamation of
of `) = 3,570.2
science and art. The scientific part goes to the extent of
informing the model; the art, however, determines the final
Net income for City Union Bank for 2017 (in crore
value.
of `) = 502.77
Banks present an interesting scenario for valuation as
there are a multitude of approaches dictating the process. Using the CAPM model, cost of equity capital for City
Even as the conventional methods like the discounted cash Union Bank = 0.0717 + (1.24 × 0.051) = 0.13494
flow (DCF) approaches evidenced in dividend discount From Equation (1), Equity charge = 3570.2 × 0.1394
model (DDM) and free cash flow to the firm (FCFF) model = 481.763.
present significant computational challenges, relatives
approach present by far the most realistic approach for Therefore,
valuation of banks. Prominently, the price-to-earning (P/E) Residual income (Rt) = 502.77 – 481.763 = 21.0072.
and price-to-book value (P/BV) techniques appear to be
the most popularly employed techniques by the analysts It is assumed that City Union Bank will enjoy a supernormal
covering banks. growth period of 10 years after which it slips into terminal
Appearing from the relative obscurity is the residual growth. During the supernormal growth phase, the growth
incomes approach. Given the underlying conceptual basis rate is essentially computed as follows:
grounded on the equity model, residual income approach in gs = ROE x RR, (3)
some sense acts as a compromise between the DCF and
relatives approaches on the extreme ends of the continuum. where
Without relying excessively on unimaginable number of ROE = Return on equity
inputs, the residual income approach nevertheless incorpo-
RR = Retention ration = 1 – Payout ratio.
rates the discounting function retaining the conceptual
DPS
rigour. Payout ratio = < F,
In its simple sense, EPS
where
Residual income (Rt) = Net income – Equity charge, (1)
DPS = Dividend per share
where
EPS = Earnings per share.
Equity charge = Equity capital × Cost of equity
378 Vision 24(3)

Table 1.  Residual Income Approach to City Union Bank (Range 1)

Years 0 1 2 3 4 5 6 7 8 9 10 Terminal Year

Residual income (crore of `) 21 24 27 31 35 40 45 51 58 66 75 80
Terminal value 1,576
PV of residual earnings (A) 655
Book value (B) 3,570
Total value (C) = (A) + (B) 4,226
Number of shares (D) 60
Intrinsic value per share = (C)/(D) 70
Source: The author.

Table 2.  Residual Income Approach to City Union Bank (Range 2)

Years 0 1 2 3 4 5 6 7 8 9 10 Terminal Year

Residual income (crore of `) 92 105 119 135 154 174 198 225 255 290 330 351
Terminal value 9,830
PV of residual earnings 4,333
Book value 3,570
Total value 7,903
Number of shares 60
Intrinsic value per share 132
Source: The author.

In case of City Union Bank, the figures of DPS and EPS for Estimated beta = 0.98
2017 are given at `0.3 and `8.36, respectively, generating
a payout ratio of 0.03589. Given that the ROE for 2017 is Terminal beta = 0.7 (assuming the risk of the stock will
14.08 per cent, using Equation (3) yields a supernormal be much lesser than the market).
growth rate of 0.13575 or 13.575 per cent. An excel output involving the above amendments is
In respect of the terminal valuation, it is assumed that presented in Table 2.
the bank’s beta converges with the market beta with β = 1. With these changes, it may be observed that the intrinsic
Substituting the beta value yields a terminal cost of equity value of the share rises to `132. As an analyst, it is there-
at 0.1227. Further, it is assumed that the terminal growth fore best advised to indicate the valuation in a range using
rate reverts to the risk-free rate at 0.0717. It is assumed that multiple approaches than thrusting a single number based
the City Union Bank enjoys a supernormal growth period on a single approach. Would relatives be better suited to
of 10 years after which it will be slipping into the terminal value City Union Bank? That is another interesting dimen-
stage. sion best left for the discerning readers to figure out!
An excel output underlying the computations is
presented in Table 1.2
Attesting to the fact that valuation is partly science and ORCID iD
partly art, it may be vouched from the above analysis that Ullas Rao https://orcid.org/0000-0001-5862-8659
the residual income approach yields an extremely conserv-
ative value pegging the intrinsic value of share at `70.
However, as is the case in any valuation exercise, there is Notes
no final word as such. 1. Readers wanting further details on the processes underlying
To better mirror the prevalent market realities, if the DCF approaches are encouraged to refer to any standard text
analyst were to make minor adjustments underlying the on valuation or contact the author.
above inputs: 2. Due to want of space, decimals have been rounded-off.

Risk-free rate = 0.065