2.Based on your analysis, does the HDFC Bank Stock have the right attributes to be a long-term investment for the equity portfolio of a pension fund? Provide a reasoned justification for your answer.

On the evening of September 24, 2018, two analysts who worked for a pension fund were discussing a request they had been given by their employer. They were asked to select a banking stock for the purpose of long-term investment as part of an equity portfolio. The assignment involved evaluating and identifying a banking stock that possessed core fundamental strength. During fiscal year (FY) 201718, the banking industry had witnessed stressed balance sheets with rising non-performing assets (NPA),2 although growth in credit was offering a more positive outlook for the coming years. Losses incurred by some banks, coupled with deterioration in asset quality, made it imperative for the two analysts to identify and select a set of banks that were fundamentally strong and that would keep the portfolios exposure away from unnecessary event risk.

In their management program, the two analysts had learned about an analysis approach that covered capital adequacy, asset quality, management quality, earning ability, liquidity, and sensitivity to market risk (CAMELS). This framework, would help them evaluate the relative performance of banks to screen and identify a bank that was potentially strong and stable. In the first stage of their analysis, they used the CAMELS approach to identify HDFC Bank Ltd. (HDFC Bank) for further study and valuation. In the next stage, they applied the traditional discounted cash flow (DCF) technique to arrive at the final valuation of HDFC Banks stock price. On September 24, 2013, the banks stock price was 639.3 By the time the two analysts were conducting their valuation on September 24, 2018, the stock had risen to 1,925.70 (see Exhibit 1). Their own final analysis resulted in a stock price of 2,254.14 per share as of September 24, 2018. Given the strong fundamentals of HDFC Bank, was this the bank stock that the two analysts were looking for to be part of the pension fund portfolios long-term investment strategy?

THE INDIAN BANKING INDUSTRY Indias central bank, the Reserve Bank of India (RBI), regulated the Indian banking system. The structure of the banks in India was broadly based on the classification given by the RBI. Banks were broadly categorized as scheduled and non-scheduled. On September 24, 2018, the total number of banks comprised 21 private banks, 27 public sector banks, 49 foreign banks, 56 regional rural banks, 1,562 urban co- operative banks, and 94,384 rural co-operative banks. In addition to these classifications of the banking sector, there were several other categories that included co-operative credit institutions and various financial institutions across all of India or at the state level.4 The banking industry had witnessed a significant increase in demand for credit from 2007 to 2018, at a compounded annual growth rate of 10.55 per cent,5 which included demand from the retail and corporate segments. Deposits also witnessed a growth trajectory of 11.66 per cent during that period. This growth could be attributed to rising disposable incomes fuelling savings and, thereby, demand (see Exhibit 2). FY 2018 saw a decline in the asset quality of public sector banks, primarily due to poor credit appraisal systems with gaps in the management of post-sanction monitoring and standards. Private banks had relatively better asset quality, with higher provisioning in their books and improved recovery that translated into lower gross NPAs. Overall gross NPAs as a percentage of gross advances were 11.2 per cent in FY 2018, compared to 9.3 per cent in 2017. They were 3.8 per cent for foreign banks, 4.7 per cent for private banks, and 14.6 per cent for public sector banks.6 From 2017 to 2018, with the rapid pace of re-monetization, growth in deposits of current accounts and savings accounts was diluted in both public sector and private banks despite an increase in foreign banks7 (see Exhibit 3). In March 2018, the shares of current, savings, and term deposits stood at 9.7 per cent, 32.1 per cent, and 58.2 per cent, respectively. Term deposits also saw an increase, although returns were inadequate compared to other financial investment avenues such as mutual funds, pension funds, and others. The bulk of deposits was contributed by the household sector, followed by the foreign sector and the financial sector. In 2018, the banking industry evolved as a result of two major initiatives. First, the RBI issued a directive to banks to resolve bad loans and breakthrough in India, which was coupled with the Insolvency and Bankruptcy Code of 2016 for the resolution of stressed assets. Second, urban co-operative banks could convert to small finance banks to gain a presence across the country. Since 2014, Indias prime minister had set a major objective for the overall financial inclusion of all the citizens in the country. The Jan Dhan Yojana financial inclusion program was a major step toward this goal, which led to the establishment of non-banking finance companies, small banks, and payments banks. A new version of the Unified Payments Interface also positioned the banking system to reap benefits from technology.8 All these steps helped widen the reach of banks across the country and provided access to a good banking system for all citizens. A positive outlook for the Indian banking sector seemed assured.

HDFC Bank was incorporated in 1994 with a registered office in Mumbai. It was among the first to receive an in principle RBI approval to be set up as a private bank. It was set up as a part of the liberalization program of the Indian banking industry and commenced operations as a scheduled commercial bank in January 1995. With this legacy and backing, HDFC Bank proceeded to augment its core values of operational excellence, customer focus, product leadership, people, and sustainability. As of March 31, 2018, the bank had 4,787 branches across 2,691 cities, which were centrally linked on a real-time basis.13 This was a reflection of customer satisfaction, which was exhibited in the banks performance over the year (see Exhibit 5). In 2018, HDFC Banks ratio of NPAs to net advances was 0.4 per cent, which was considerably lower than its peers. The bank also had a diversification advantage. HDFC Bank was not limited to retail banking; it actively pursued interests in treasury, wholesale banking, and other banking services. The contribution of these sectors was 49.91 per cent of the banks total revenue for FY 2018, whereas the profit contribution was 62.64 per cent (see Exhibit 5).14 FINANCIAL PERFORMANCE AND MANAGEMENT OUTLOOK HDFC Bank reported a net profit of 1.7487 billion for FY 201718, registering a growth of 20.2 per cent over the previous financial year. With the implementation of the governments demonetization program15. and the goods and services tax (Indias biggest indirect tax reform, introduced on July 1, 2017), the Indian banking system went through a phase of economic adjustment in 2018. The bank earned 65.6 per cent of its revenue from interest on advances, 18 per cent from interest on investments, and 12 per cent through commissions, exchange, and brokerage. The net interest income witnessed a growth of 21 per cent, while other sources also showed an upward trend (see Exhibit 6). The capital adequacy ratio stood at 14.8 per cent, well above the regulatory minimum of 10.875 per cent. Gross NPAs were 1.30 per cent of gross advances, and net NPAs were 0.4 per cent, among the lowest in the industry. The asset position of the bank was robust thanks to its prudent credit evaluation procedures and diversified loan book across customer segments, products, and sectors.16 The banks total balance sheet size stood at 106.3934 billion as of March 31, 2018. Deposits were 78.8771 billion, for an increase of 22.5 per cent over the previous year, while advances stood at 65.8333 billion, for an increase of 18.7 per cent over the previous year. The return on capital was registered at 18.2 per cent (see Exhibit 6). RBI identified HDFC Bank as a systemically important domestic bank. Following a trend in the Indian economy, HDFC Bank had digitized 85 per cent of all transactions by the end of March 2018.17 VALUING HDFC BANK: DISCOUNTED CASH FLOW VALUATION METHOD The DCF method18 involved estimating HDFC Banks future cash flows, which could stem from different growth outlooks, and then discounting them back to present values by the current cost of capital of the entity. The value thus obtained represented the intrinsic value of the firm. Subsequent decisions could be made by analyzing this intrinsic value to the traded value in the stock market. The process of DCF valuation included four steps. The first step was to estimate the discount rate or rates to use in the valuation. The second step was to estimate the future earnings and cash flows for the firm being valued, generally by estimating an expected growth rate in earnings. The third step was to estimate when the firm would reach stable growth and what characteristics (risk and cash flow) it would have at that point. The fourth step was to calculate the value of the firm by adding the explicit phase and the terminal phase. Free cash flow to the firm (FCFF) could be defined using the following formula: Present Value of FCFF = [1][](1+) In the formula, EBIT represented earnings before interest and tax, Capex represented capital expenditures, NWC represented net working capital, K represented the discount rate or cost of capital, and N represented the year for the free cash flow. Terminal Growth Phase In the existing scenario, it was assumed that the bank would maintain its high growth rate for a specific period. It would then experience a transitional period, where its characteristics would change gradually toward stable growth levels. The complete process would comprise a three-stage model. To determine the length of the extraordinary growth phase, size of the firm, existing growth, and excess returns, the magnitude and sustainability of its competitive advantage were considered. The terminal growth rate was the constant rate at which a firms expected free cash flows were assumed to grow indefinitely. This growth rate was used in a DCF model beyond the forecast period for the end of the forecasting period into perpetuity. The terminal growth rate value was based on the going concern concept for HDFC Bank, with cash flows growing forever at a constant rate. Therefore, the terminal growth phase value of the firm was calculated using the following formula: +1= (1+) In the formula, FCFFn represented free cash flow to the firm in the last year of the explicit growth phase, K represented the cost of capital or discount rate in the terminal growth phase, and g represented the growth rate for the stable growth phase. FORECASTING CASH FLOWS FOR DISCOUNTED CASH FLOW VALUATIONS DCF valuation primarily focused on three components: growth rates over the forecasted period, cost of capital of the company, and present-day FCFF. The two pension fund analysts knew that both cost of capital and FCFF could be calculated based on the publicly available reported figures, but they were uncertain about the growth rates because their approximation was highly subjective. Therefore, they determined the growth rate for the forecasted period, followed by the growth rate for the terminal phase. They referred to HDFC Bankss investor presentation and its financial statements to determine forecasted cash flows. One factor advocating significant and sustained growth in the future for the bank was its strong corporate governance, reflected in the composition of its board of directors, with high eminence and credibility in the financial markets. Also, given the strong indicators for the bank as reflected in the CAMELS analysis, both analysts were convinced about using a three-stage DCF model, with two stages of explicit growth followed by a constant growth. Loans and advances showed growth of almost 18.7 per cent over the previous year, while gross advances increased by 23.8 per cent in 2018.19 The two analysts followed the growth rate computation using return on equity and retention ratio variables and arrived at 12.62 per cent for the first five years, followed by 10 per cent for the next five years, and converged the growth rate to 6 per cent in the terminal phase.20 For the cost of capital calculation, beta was determined as 1.05 for the explicit growth phase, converging toward a market beta of 1.0 in the terminal phase. The risk-free rate was taken from the 10-year Treasury bond rate, which was 7.75 per cent in September 2018. They followed Damodarans model21 to determine a countrys equity risk premium and identified it as 7.87 per cent for India. This was based on an average of historical and implied risk premium determined for the Indian markets. For the cost of debt, they used the credit rating assigned to HDFC Bank