Why HDFC Bank is Undervalued: A Strategic Investment Opportunity

HDFC Bank, India's largest private sector bank with a market capitalization of approximately USD 150 billion, is currently undervalued. Despite its strong fundamentals and significant market position, its stock price does not fully reflect its future growth potential. HDFC Bank has a dominant position in the Indian banking sector, which provides a solid foundation for long-term growth, especially with the expanding Indian economy. For more information, view this video to find out more:

HDFC Bank, India's largest private sector bank, with a market capitalization of approximately USD 150 billion, is currently undervalued. Despite its prominent position in the Indian financial landscape and its strong fundamentals, the bank's stock price does not fully reflect its potential for future growth and profitability. Here's why:

1. Dominant Position in the Indian Banking Sector

HDFC Bank has established itself as the largest bank in India, not only by assets but also by market capitalization. With a market cap of INR 12.22 trillion (as of August 15, 2024), the bank holds a significant share of the Indian banking market. This dominant position offers HDFC Bank a strong foundation for sustained growth, especially as the Indian economy continues to expand.

2. Growth in the Indian Housing Finance Market

The Indian housing finance market is expected to experience record growth of 24% from 2024 to 2033. As one of the key players in this sector, HDFC Bank is poised to benefit significantly from this expansion. The bank's recent merger with HDFC Ltd., a leading housing finance company, positions it to capture a larger share of this booming market. The merger integrates HDFC Ltd.'s expertise in housing finance with HDFC Bank's robust banking infrastructure, creating a powerful synergy that enhances the bank's long-term growth prospects.

3. Merger-Related Short-Term Profitability Decline

The 2023 merger between HDFC Bank and HDFC Ltd. has temporarily impacted the bank's profitability metrics. The profit margin has decreased from its pre-merger high of 30% to 22%, and earnings per share (EPS) have remained flat since the merger. These declines, however, are not reflective of the bank's long-term earning potential.

According to the bank's CEO during the “HDFC Bank Limited Earnings Call” on April 20, 2024, the profitability metrics are expected to normalize within two to three years post-merger. This temporary dip in profitability should be viewed as a strategic investment phase, as the benefits of the merger are expected to materialize fully in the coming years.

4. Attractive Valuation Metrics

Currently, HDFC Bank's price-to-earnings (PE) ratio stands at 17.9x, the lowest since the COVID-19 pandemic. This low valuation presents an attractive entry point for investors, especially when considering the bank's future earnings potential.

If the bank's net margin increases back to 30%, its net income could rise to approximately INR 873 billion, assuming no change in revenue. This would result in a forward PE ratio of just 14x, significantly lower than the current PE. Such a reversion in profitability would make HDFC Bank's stock even more undervalued compared to its historical averages.

5. Long-Term Value Proposition

The current undervaluation of HDFC Bank should be seen in the context of its long-term growth trajectory. The merger with HDFC Ltd. is a transformative event that, despite its short-term challenges, enhances the bank's strategic positioning in the market. With the expected normalization of profitability and the significant growth in the housing finance market, HDFC Bank is well-positioned to deliver substantial value to its shareholders over the long term.

Conclusion

HDFC Bank's current undervaluation provides a compelling investment opportunity. The bank's leading market position, growth potential in the housing finance sector, and the expected recovery in profitability metrics post-merger all point to a strong upside for investors. As the market begins to recognize these factors, HDFC Bank's stock price is likely to adjust upward, offering significant returns for those who invest now.

Calculations – Pessimistic situation (as at 19 Aug 2024)

Assumptions:

All figures in INR
Net Income growth rate 12% (5-year average was 24.06%)
Share outstanding growth rate 6.73% (5-year average)
Dividend Growth Rate 0% (5-year average was 21%)
Terminal Price/Earnings 18x (5-year average was 22.11x)
Discount Rate: 10%
Most recent Net Income INR 681.7B.

Step 1: Project Net Income / Earnings

The most recent Net Income / Earnings value is ₹681.665B as of 2024-06-30.
We will project this out 5 year(s) with a yearly growth rate of 12.00%.
We estimate the Net Income / Earnings will be ₹1.201T.

Step 2: Project Future Shares Outstanding

The most recent Shares Outstanding value is 7,617,490,000.
We will project this out 5 year(s) with a growth rate of 6.73%.
We estimate the Shares Outstanding will be 10,549,805,184.

Step 3: Project Future Dividends Paid

The most recent forward dividend per share value is ₹19.50.
We will project this out 5 year(s) with a growth rate of 0%.
Based on this growth rate, over the next 5 year(s) the stock will pay ₹97.50 in total dividends.
We then add the total dividends paid and the future stock price together to find the total shareholder returns.

Step 4: Project Future Stock Price

We will use the projected Net Income / Earnings and Shares Outstanding values, as well as the price ratio of 18.00 to calculate the future share price.
The formula for this is: Projected Future Stock Price = (Future Net Income / Earnings Projection / Future Shares Outstanding Projection) * Price Ratio = (₹1.201T / 10.55B) * 18.00 = ₹2,049.695.

Step 5: Discount the Projected Stock Price & Dividends Paid

We have the Projected Stock Price and the Total Dividends paid, we will now use them and our discount rate of 10.00% to discount the value back to a current day price.
When we discount the price by 10.00% over 5 year(s), we get a DCF stock price for 2024-06-30 of ₹1,333.24.

Step 6:

Based on the current price of ₹1,632.10, the IRR projected to be 5.6% over next 5 years.

Calculations – Baseline case (as at 19 Aug 2024)