Neither PE nor PB, Saurabh Mukherjea uses this metric to pick financial stocks

“This anomaly leads to most investors either ignoring fundamental valuation methods or following thumb rules such as P/E and P/B multiples. At Marcellus we use the ‘Residual Income’ (RI) model to best capture the economic value add of a financial services company,” says Dalal Street’s top stock picker Saurabh Mukherjea.

RI is calculated by subtracting return on equity (RoE) with the cost of equity (CoE). “Our job is to assess the ROE potential of the business and the longevity of the period during which ROE is in excess of COE. The greater the RoEs, the greater longevity of a lender or insurer, the greater the fair value of the business,” says Mukherjea.

Explaining the excess returns valuation model, the money manager known for sticking to his consistent compounding style of picking stocks said the concept is similar to that used for determining Net Present Value (NPV) of any project wherein the NPV is positive only if the project earns returns higher than the cost of capital.

“Analogously, a Financial Services firm that is expected to earn returns higher than its cost of equity would ideally have a fair value higher than the equity capital currently invested (i.e. its book value) while a firm which struggles to do so should have a fair value lower than the current equity capital,” he said.

A comparison of the PB ratio for Indian banks as of FY13 with the next 10-year share price CAGR shows that ‘expensive’ lenders (i.e. the ones with the highest value of Price to Book ratio) have generated the highest returns.

A low price-to-book ratio in itself does not have any predictive power and generally suggests a poorly run lender, Mukherjea said in a note to investors.”India’s best lenders are able to generate high Return on Assets (RoA) and RoE year after year which in turn allows them to reinvest higher amounts back into their equity base for future compounding,” he said.

Financial stocks that are part of his Kings of Capital fund include HDFC Bank, Bajaj Finance, Kotak Mahindra Bank, ICICI Bank, HDFC Life, Axis Bank and ICICI Lombard.

“By owning these quality financial companies, we intend to benefit from the consolidation in the lending sector and the financialization of household savings over the next decade,” Team Marcellus said. Since its inception in July 2020 the fund has underperformed by delivering a return of 6.13% against Nifty Bank’s 26.6% upside.

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