Banks' valuation discount to Sensex hits 10-year high

Banks, the biggest component of the Indian equity market, are now trading at a big discount to the benchmark indices.

The BSE Bankex index, which tracks the share price of the 10 top listed banks, is trading at a trailing price to earnings (P/E) multiple of 15.3X, nearly a 40 per cent discount to the BSE Sensex current P/E of 24.37X.

This is the biggest valuation gap between the two indices in at least 10 years.

Similarly, the BSE Bankex price to book ratio (P/B) of 2.22X is 40 per cent lower than the current Sensex P/B ratio of 3.61X.

This is due to a relatively poor showing by top banking stocks on the exchanges in recent months.

Analysts attribute this to the prospects of their muted earnings growth in the next few quarters.

“Banks’ profitability is likely to face multiple headwinds, including margin compression from higher deposit costs, rising competition in retail lending, and a deterioration in asset quality in consumer lending businesses,” said Dhananjay Sinha, co-head, research and equity strategy, Systematix Institutional Equity.

Analysts at Kotak Institutional Equity, in their recent report on the earnings outlook for the banks, wrote: “Banks’ operating profit growth is weak because the contraction cycle in the net interest margins (NIMs) is underway.

"We expect banks to report a 15-20 basis point decline in NIMs.

"While loan yields have limited room for expansion, we see deposit costs likely to re-price higher.”

Others blame HDFC Bank for the relatively poor showing of the banking index.

The bank’s stock declined nearly 20 per cent after its Q3FY24 earnings.

Relatively poor earnings in Q3FY24 also triggered a selloff in Axis Bank, IndusInd Bank, and AU Small Finance Bank.

“HDFC Bank is the single-biggest culprit in relative under-performance and the valuation discount of the banking index.

"At one time, it used to trade at a P/E of nearly 30X, which is now down to 20X, while its P/B ratio has shrunk to 2.7x from close to 5 at the peak,” said G Chokkalingam, founder and chief executive officer, Equinomics Research Pvt Ltd.

Banks remain the biggest component of the benchmark index with a weighting of 32.1 per cent in it.

There are five banks, led by HDFC Bank, which has a weighting of 13 per cent. In comparison, there are 10 banks in the BSE Bankex index.

Banks are followed by information-technology services companies such as Tata Consultancy Services and Infosys with a combined weighting of 15.3 per cent in the index.

At its current valuation, the banking index is trading at a discount to its average valuation the last 10 years while the benchmark index is at a premium to its average valuation in the last decade.

In the past 10 years, the BSE Bankex P/E multiple has been 24.2X, on average, nearly 50 per cent higher than its current P/E multiple.

Similarly, the Bankex P/B ratio has been 2.3X on average in the past 10 years, 4 per cent higher than its current P/B ratio.

In contrast, the current Sensex P/E multiple is 5 per cent higher than its 10-year average P/E multiple of 23.5X while its current P/B ratio is nearly 20 per cent higher than its 10-year average P/B ratio of around 3X.

In the past 12 months, the BSE Bankex P/E multiple has declined by 90 basis points from 16.2X at the end of January 2023 to 15.3X.

In the same period, the Sensex P/E multiple expanded by 230 basis points from 22.3X at the end of January 2023 to 24.6X.

The banking index price to book value has also declined by nearly 10 basis points in the last 12 months compared to an expansion of 36 basis points in the Sensex P/B ratio during the period.

One basis point is one-hundredth of 1 per cent.

This is a trend reversal for the banking index, which traded at a premium to the broader market during the pre-pandemic period.

For more than three and a half years -- between August 2016 and February 2020 -- the BSE Bankex trailing P/E multiple was higher than the benchmark index.

Analysts say poor showing by banks is weighing on the broader market, given its still large weighting in the benchmark indices.