I was recently watching this interview of Kiran Shaw wherein she talked about the benefits of being a listed company; do watch this from 01:02:00-
What she said about having a capital value that you can use for a company’s capital needs makes so much sense. And this is best applicable to lending businesses wherein capital raises is a regular business activity.
A lending business is about raising capital and lending that capital forward at a higher yield than at what you have borrowed it at. Equity is an important part of a lender’s overall capital base given that you can leverage your balancesheet only to a certain extent.
But unlike other businesses wherein raising equity capital leads to dilution of shareholder’s earnings & returns, in lending businesses, equity dilutions can actually improve shareholders returns. This is because lenders are valued at a multiple of their book value (equity value) and thus higher the equity - higher is the market cap; and anytime a lender raises equity capital at a valuation multiple of >1x its book, the book value per share actually goes up.
Consider this example-
Lender X has a book value of Rs1000 and 100 issued equity shares i.e book value per share is Rs10. And it trades at say 3x its book value and thus its total market cap is Rs3000.
Now if Lender X raises equity capital of Rs300, its book value will increase by 30%, however, the number of shares will not increase by 30%, it will increase by only 10% given that for raising Rs300 at a market cap of Rs3000, it will only have to dilute 10% of its capital.
And thus, the book value per share increases to Rs11.8 per share (Rs1300 book value / 110 shares); ie. an increase of ~18%.
In-fact, the higher the multiple that the lender trades at, the higher would be the gain in book value per share. In the same example above, if the Lender X was trading at 5x its book value, the gain in book value per share would have been ~23%.
Bajaj Finance is a great example of how this equity dilutions can supercharge you book value per share growth-
Based on above calculations done by CLSA, without considering the accretion due to equity dilutions, Bajaj’s book value per share between FY16 & FY20 would have grown from Rs120 to Rs347, whereas the actual book value had increased to Rs540; ie. extra 56% increase due to dilutions at valuation multiple >1x.
In-fact, Bajaj has always raised capital at very high multiples of 6-8x price-to-book thus getting a much larger benefit of equity dilutions.
Thus, in a lending business if you get frequent capital raises at high valuations, you get very strong compounding. And this frequency of capital raises depends on the difference between the company’s loan book growth and the ROE that it generates.
If a lender grows its loan book at much higher rates than its ROE, its leverage will increase and thus it will have to raise equity capital to keep the leverage in check.
Bajaj Finance historically grew its loan book at 35%+ rates while its ROE was ~20% and thus every 2 years, it came to capital markets to raise capital. An opposite example of this is that of Muthoot Finance, wherein its ROE is ~25%, but loan book growth is ~15% and thus it generates more capital than it needs and thus Muthoot has not raised capital since its listing.
In summary, loan book growth > ROE + high valuation multiple is where magic happens in lending businesses; leading to exponential growth in book value and thus the stock price.
That’s it for this week, new insight coming up next week. So stayed tuned!
Surge Capital is a trade/brand name used by Ankush Agrawal (Individual SEBI Registered Research Analyst INH000008941) to provide equity research services in the Indian Equity Markets.
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Stock specific investment disclosure:
Bajaj Finance- Invested. Not Traded in last 30 days. Active recommendation in Research Service
Muthoot Finance- Not Invested. Not Traded in last 30 days. Not an active recommendation in Research Service