DBS Group: Perhaps What Peak Bank Valuations Look Like (OTCMKTS:DBSDF)

Businessman At Top Of Mountain Peak Holds Large Flag

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In wanting to test and demonstrate and our bank-stock valuation model with inputs from a top-tier bank, we looked to DBS (OTCPK:DBSDF), the Singapore-based bank bestowed with the mantle of ‘World’s Best Bank‘ multiple times in recent years. We concluded that that our prediction of strong future earnings growth and the unlikelihood of material negative shocks from downside risk events alone did not make up for the fact that our perceived level of fair value still fell short of current price levels. We looked to strengthen conviction in our valuation model by evidencing industry peers with recent price movements that corroborated with our views.

The Company

DBS has a traditional banking model focused on retail and institutional banking, which drives 80% of earnings. It also operates almost exclusively in Asia, with its domestic operations in Singapore making up 70% of the firm’s business.

Based on its latest reporting, its 2022 half-yearly earnings of S$3,616m equated to an impressive 13% return on equity, while maintaining a decent CET1 ratio of 14.2%. As expected, the majority of P&L contribution was derived from net interest income, with net interest margin gradually widening in recent times in conjunction with the rising interest rate environment.

DBS net income margin

DBS’s ability to source funding at such low costs is an inherent competitive advantage. In a rising interest rate environment, we expect net interest margin to continually increase near-term. (DBS Q2 2022 Performance Summary)

These results continued a trend of strong results over the last 10 or so years, whereby it has averaged 11% RoE. Even during its worst year (2020), when over S$3,000m in credit provisions were recorded, it still managed to deliver 8.7% earnings growth.

DBS track record

Post-GFC earnings have been remarkably resilient – even during 2020 DBS managed a RoE of 8.7% (Woodforde Investments)

Forecasted Outlook

With its outsized market dominance in Singapore, we see DBS likely to continue to attract new funds at cheap rates without losing market share to competitors, in an economy that is forecasted to continue expanding at close to 5%. Coupled with an interest rate environment expected to be on average higher than the near-zero levels seen in the last decade, we envision DBS increasing net interest margins, and perhaps could stretch its RoE to 14% in 2023.

However, we are mildly concerned about its concentration to the property sector, with construction-related loans to corporates and housing loans to individuals making up 44% of its loan book. With Singapore property prices notoriously high, and fixed-rate mortgage rates not actually fixed for the full maturity of the loan, we remain wary of higher interest rates eventually squeezing customers and possibly resulting in a substantial default cycle impacting the Singapore housing market. We don’t expect to see the bank record net losses in such an environment, but can foresee it hindering profitability as it did during 2020.

Customer Loan exposure

We are mildly concerned about the exposure DBS has to the (Singapore) property sector, and are not convinced that it will continue to hold up during the coming years. (DBS Q2 2022 Performance Summary)

We predict that over the next decade the average RoE will settle between 11-12%, with perhaps a couple of years of outlier performances on both ends of the spectrum (i.e. some years closer to 14% growth, and some years of single digit returns). Our model suggests that current fair value of the stock based on these growth assumptions is around S$26, with approximately $11 of that representing amounts to be returned to shareholders via dividends. Stock prices at this level would in current terms represent a P/B ratio of 1.2 and P/E of just under 10.

DBS risk-reward

Our valuation model suggests S$26 (EPS of 2.6 x P/E 10x) as fair value. Although current valuations (S$34) still reflect a positive risk-reward proposition, its variance from our derived valuation is unsettling. We wonder if DBS deserves such a premium by mere virtue of being a better performing bank. (Woodforde Investments)

Valuation

At time of analysis, DBS stock is trading close to S$34 (US$23), which equates to a P/B of 1.5 and P/E closer to 12x. Our analysis suggests that although distant from our calculated fair-value of S$26, these current levels still represent healthy upside potential and limited downside concerns.

However, we wanted to gain greater clarity as to whether the disparity to our derived fair value was a limitation of our model, perhaps unable to quantify a premium that a higher-performing bank could be afforded.

In order to understand further, we attempted to (1) compare with global peers we think have a similar competitive standing, and (2) look back at recent historical P/B movements of DBS and these peers.

The below diagram shows that DBS shares moved above P/B of 1.2 in 2021, once it was clear that 2020 was an aberration and returns to pre-pandemic earnings growth was likely. Our hypothesis is that by moving above P/B of 1.5 (and corresponding P/E of 15x), the market starting (mis)pricing in expectations that RoE would continue to grow upwards (past 12%). In establishing our base-case that future earnings will only average 12% growth over the long term, we think that the stock overshot its fair value during the fervour of the reopening trade.

DBS historical P/B

We observed that the stock moved above our derived fair value of 1.2 P/B in 2021, as its RoE returned back to pre-pandemic levels. However, whereas we expected P/B to normalise closer to 1.2 (green arrow), we think the stock price overshot during the recovery phase from 2020, and has not yet returned to fair value. (Seeking Alpha)

Peer Comparisons

To be fair, we noted that this valuation overshooting phenomena was not isolated to DBS, and for demonstration’s sake we can see that when comparing with JP Morgan (JPM) and BofA (BAC).

RoE vs P?B

We noted that both JPM and BAC’s P/B values also moved up and down during 2020-2022 in line with their RoE, and generally speaking there is a strong direct correlation between RoE and P/B for all 3 banks in recent history (Seeking Alpha)

To expand on JP Morgan, in 2021 they achieved a RoE of 17%, largely driven by the release of credit provisions taken on in 2020 during the depths of the pandemic. Therefore, the nature of 2021 outperformance was always expected to be a one-off, however by trading at P/B of 2 (and corresponding P/E of 17x) during its peak the market was almost pricing in future RoEs approaching 20%. Alas, we have seen P/B for settle back to a more reasonable level of 1.3 as RoE for JPM have declined to (a still solid) 13% (ttm basis). We saw a similar pattern with BofA as their RoE rebounded from 6.6% (2020) to 11.8% (2021) and settled back to 10.1% (2022 YTD).

The re-rating of JPM and BAC back to a band between 1.0-1.2 P/B is in line with our assessment of these banks’ fair value, and yet we note that DBS is still floating above that level.

That’s not to say that DBS is overvalued at current prices, but if we were a current shareholder we would considering realising some gains if valuations remained elevated without future RoE projections also being revised upwards. On the other hand, if we were looking to increase banking exposure, we think there are peers of equivalent-quality (JPM and BAC as examples) which have undergone a recent price correction and perhaps offer better relative value.

Conclusion

We see DBS continuing to deliver market-leading returns in the next decade, although there is a minor possibility of an earnings growth hit if the Singapore property sector suffers distress. We think a current shareholder can take comfort in the safety and magnitude of future returns from the investment, however current prices are too high for us to suggest initiating a long position.

We cite the shares of JP Morgan and BofA as also experiencing a similar valuation mispricing before normalising to what we deem as fair value, and therefore would not be surprised if DBS’s stock price feels gravitational pull towards S$26 when it delivers realistic (although still healthy) results in upcoming reporting periods.

(Reported S$ amounts reference SGD as the reporting currency of DBS)

(USDSGD=1.40 assumed in analysis)

(10y risk-free-rate of 4% assumed in analysis)

(Discrepancies exists between RoE as calculated by Woodforde Investments, and as provided by Seeking Alpha, likely due to differing assumptions on earnings and equity values, as well as slippage from fx translation. We assessed the differences to be immaterial)

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