Justified P/B and Risk Assessment for Sundara Finance
Sundara Finance Ltd is a listed non-banking finance company. Its shares trade at ₹480. Book value per share is ₹300, return on equity is 14%, the cost of equity is 13%, and the dividend payout ratio is 40%, implying a sustainable growth rate of 8.4%. The company has grown its loan book aggressively, funded largely by short-term borrowings, and its asset-liability mismatch has widened. Credit costs are currently low, but the regulator has proposed higher risk weights for one of its main lending segments. An analyst covering the stock uses a Gordon-growth justified price-to-book model and assumes the current ROE and growth rate are sustainable. A colleague argues that the stock is “cheap” because it trades at only 1.6 times book, while historical peer multiples were above 2 times book. The investment committee wants a clear recommendation with sensitivity analysis.
1. Calculate the justified P/B ratio and justified value per share using the Gordon-growth model. State whether the market price is supported.
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The justified P/B for a stable-growth financial firm is:
Justified P/B = (ROE − g) / (r − g)
where ROE = 14%, g = 8.4%, and r = 13%.
Justified P/B = (0.14 − 0.084) / (0.13 − 0.084) = 0.056 / 0.046 = 1.217.
Justified value = 1.217 × ₹300 = ₹365 per share.
At ₹480, the market is pricing the stock at 1.6 times book, well above the justified 1.22 times book. On the analyst’s assumptions, the market price is not supported by fundamentals. The “cheap at 1.6 times book” argument is a relative-multiple argument; it does not answer whether 1.6 times book is justified given Sundara’s ROE, growth and cost of equity. A peer multiple above 2 times book may reflect higher ROE, lower risk or higher expected growth at those peers, not a re-rating case for Sundara.
2. Test the sensitivity of the valuation to growth and cost of equity. What does this imply about the investment case?
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The valuation is highly sensitive because the spread between ROE and r is narrow. If growth rises to 9% while r remains 13%, justified P/B = (0.14 − 0.09) / (0.13 − 0.09) = 0.05 / 0.04 = 1.25, or ₹375 per share. If the cost of equity falls to 12% and growth is 9%, justified P/B = 0.05 / 0.03 = 1.67, or ₹500 per share - which would make the market price roughly fair. If growth stays at 8.4% but r rises to 14%, the model breaks down because r equals the growth assumption; the value becomes extremely sensitive and the stable-growth model is no longer reliable.
The implication is that the recommendation cannot rest on a single point estimate. The market price of ₹480 requires either a lower cost of equity, a higher sustainable growth rate, or a higher ROE than the base case. Sundara’s aggressive loan growth and wider asset-liability mismatch point the other way: they increase risk, which should raise the cost of equity, not lower it. The committee should treat the “cheap” argument as unsupported and ask for a scenario-based valuation rather than a historical-multiple comparison.
3. Give a recommendation and identify the key risks that could invalidate the valuation.
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On the stated assumptions, the recommendation should be avoid or sell, with a fair-value range of roughly ₹365–₹375 on the base and higher-growth scenarios, unless the analyst can justify a materially lower cost of equity or a higher sustainable ROE. The stock at ₹480 discounts a better outcome than the fundamentals support.
The key risks are:
- Funding and liquidity risk: heavy reliance on short-term borrowings to fund longer-term loans creates refinancing and asset-liability mismatch risk; a funding shock would raise the cost of equity and compress margins.
- Credit-cost risk: low current credit costs may not be sustainable; a deterioration in the loan book would reduce ROE and growth.
- Regulatory risk: higher risk weights on a main lending segment would increase capital requirements, constrain growth, or force a capital raise and dilution.
- Model risk: the Gordon-growth model assumes stable growth and a constant ROE; for a fast-growing NBFC with changing leverage, those assumptions are fragile.
The committee should require a downside scenario with higher credit costs and a higher cost of equity, and should not accept a peer-multiple argument without adjusting for differences in ROE, leverage and asset quality.