Singapore Banks

The fundamental working of a bank is to attract deposits (savings and deposits) by offering a certain interest rate and thereafter lending out the funds as loans (housing loans, corporate loans etc) at a higher interest rate earning a spread termed as net interest margin.

Banks have to do their due diligence on borrowers to price their loans competitively and ensure that the probability of default on the whole is kept to a minimum. Banks are also required to have capital buffer to cover for these loan losses in times of recession and for daily operation needs such as to meet withdrawal requests or to do investments. Thus, regulators will need to step in and ensure that banks are solvent as banks are considered important institutions to ensure that thee gears of the economy is running. The importance of banks can be seen in the last global financial crisis in 2008.

In Singapore, the Monetary Authority of Singapore has a strong grasp on the banking sector as exhibited in their stricter requirements as compared to Basel III on capital requirements on Singapore incorporated banks. The capital conservation buffer on top of the Common Equity Tier 1 Capital Adequacy Ratio (CET 1 CAR) is estimated to be at least 12.5% by 1 Jan 2019.

Therefore, what is important when looking to invest in a bank is its net interest income growth, loans growth, net interest margin, non-performing loans rate, capital buffer and lastly return on equity, driven by the factors mentioned. As a diversification, non-interest income has also been increasing as a percentage of total income with wealth management seeing strong growth over the past few years among the 3 local bank with DBS having the largest share of wealth management income at $599 million and biggest non-interest income at $3.69 billion. However, DBS is still preliminary dependent on interest income as it represented 65% ($7.1 billion) of total income, compared to OCBC at 59.5% and UOB at 62%. DBS has seen strong growth rates in its loans and net interest income over the past few years as compared to the rest as seen in the table below. All figures are in S$ million. OCBC acquired Wing Hang bank in 2014 and that is why there is a huge increase of loans and net interest income.

How to value financial services firms?

Typically, free cash flows are computed after netting out reinvestment in the form of capital expenditure and changes in working capital. Capital expenditure by financial services firm is difficult to tabulate as banks invest mainly in intangible items such as human capital and brand name. The investments are also treated as operating expenses rather than capital expenses therefore it is difficult to measure capital expenditure for future investing needs. Free cash flow to equity holders also require us to know the change in composition of debt by firms but debt is also being used by banks as a raw material rather than capital as the funds raised can be used to lend out. In regulators’ eyes, equity is the capital which is why we have the CET 1 CAR. That is why we need to have a new definition of reinvestment needs by banks.

Credit to Prof Aswath Damodaran, he defined reinvestment by banks as the reinvestment in regulatory capital. By deducting reinvestment in regulatory capital from net income, we obtain the free cash flow to equity for financial services firms. The Singapore banking sector’s asset will grow at 2.5% and net income close to 2% over the next few years, both relatively conservative estimates given the dim outlook (CEOs of the banks are expecting low single digit loans growth in 2016). Given that regulatory capital for Singapore banks are currently between 13 - 14%, much buffer has been in place and will remain constant over the next few years and target at 15% at year 5. Free Cash Flow to Equity (FCFE) for each year is obtained by deducting reinvestment in regulatory capital from net income. FCFE is then discounted at the cost of equity calculated based on the risk free rate of 2.78%, equity risk premium of 5.75% and the regression beta of various banks, 1.1 for UOB & DBS and 1.04 for OCBC .

We have now come to the crucial terminal value which I will take year 5’s net income and let it grow 2%, a stable growth period. The stable payout ratio is assumed to be 50%. Banks in Singapore typically payout 35-45% of earnings in the form of dividends and buybacks. The cost of equity at stable period will also be assumed to be 8.76% for OCBC, a premium of 6% over existing risk free rate and 9.11% for UOB and DBS. Typically, the cost of equity of mature firms should fall but on a conservative note, we assume it remains for the stable period. Do note that the terminal value is about 70% of total equity value therefore we have to be conservative in estimates. The FCFE model generates the value of equity per share for OCBC to be $7.36, DBS $12.83 and UOB $15.06.

All estimated values are below current share prices which means that there are room for share prices to go down. The market is pricing UOB at the highest premium potentially due to its relatively smaller exposure to China and Oil and Gas (O&G) segment

Bank	Greater China Gross Loans exposure	Greater China Non-performing loans (NPLs)	Total Cumulative Allowances for Greater China NPLs
UOB	12.2% ($ 25 billion)	0.86%	not disclosed
DBS	33.5% ($ 96 billion)	0.85%	not disclosed (230% in 2013)
OCBC	26.8% ($ 56 billion)	0.43%	241%

O&G segment lending is also on the spotlight.

UOB - 3.6% ($7.7 billion)

DBS - 5.9% ($17 billion)

OCBC - 6% ($12.4 billion)

Overall NPLs

UOB - 1.48%

DBS - 0.98%

OCBC - 0.93%

CEOs from UOB and DBS sounded more positive in their latest earnings observation and said that the risk in their loan books is manageable. Meanwhile, OCBC Chief Samuel Tsien raised some concerns on the outlook on their loan books from the oil and gas segment. UOB’s optimistic outlook is understandable due to its relatively smaller exposure to China and O&G while DBS’ outlook could be due to its 148% cumulative allowances as of total NPLs. Comparing to UOB’s at 130% and OCBC’s at 120%, DBS might be the safer bet if things do not turn out as rosy as they expected since they have already set out almost 150% of allowances based on NPLs. Prices move when unexpected things happen and that is why lowering of risk is of utmost importance.

On relative valuation, DBS is the cheapest in terms of Price to Book ratio and Price to Earnings (trailing twelve months) ratio. The price is as of 2 March 2016.

Bank	P/B	P/E
UOB	0.92x	8.81x
DBS	0.89x	8.04x
OCBC	0.99x	8.78x

Based on UBS’ calculation of a 10 year average from Feb 2016 (UBS report Feb 2016) in the table  below, we can see that the banks are trading very much below the mean. Of course, mean reversion need not happen in the short to medium term. What I’m trying to imply is that if your horizon is long enough, the probability of mean reversion is higher.

Bank	Long term average P/B	Long term average P/E
UOB	1.45x	12.4x
DBS	1.33x	12.9x
OCBC	1.54x	14x

To conclude, DBS is my top pick amongst the banks as allowances is one of the better buffered against NPLs, high net interest margin at 1.77% and strong CET 1 CAR at 13.5%. Most importantly, its relative valuation and FCFE model (least premium compared to market value) is also most attractive amongst the banks. Concerns about China’s slowing growth and O&G segment should be less serious at the moment as the banks have mainly lent to strong state-owned enterprises and some allowances for O&G segment have been set. There could still be headwinds in the near future especially if China’s slowing growth problem exacerbated. I foresee prices of bank stocks to be beaten down due to a lack of positive catalyst and negative global sentiment. Positive catalysts that can trigger bank stocks to go up are rising oil prices, strong company earnings in 2016-2017, coordinated effort on fiscal policies and structural reforms among nations and lastly China’s success in the medium term to transit into a sustainable economy.

Till these events happen, I will strongly advise to accumulate DBS bank at around $13, 4.6% dividend yield, on a long term horizon. If we adjust our valuation model to 0% growth over the next 4 years and a stable growth period of 2% from year 5, the value comes out to be $11.17. 5% growth over the next 4 years will amount to $14.52. My scenario here is in the mid-range of 2-3% growth over the next 5 years and a stable growth period of 2%. The growth I assigned is not overly optimistic as can be seen during the 08-09 global financial crisis period, net income is still at low single digit growth. This explains my base case scenario to start accumulating at $13. DBS is also giving out $0.30 dividends, XD on 5 May 2016, so practically, you can accumulate at $13.30.

A side note: DBS CEO Piyush Gupta bought $2.8m in own company’s stock on 22 Feb 2016, a signal of confidence in DBS.