Could Chinese Banks Be Undervalued?

The author is Bernstein Research senior analyst Mike Werner

Since the peak of the SHIBOR (Shanghai Interbank Offered Rate) crisis in late June, the Chinese banks have staged a mini-rally as their shares are up 13%, on a weighted-average basis, outperforming the regional MXAPJ Index by 840bp over this period.

Despite this, the Chinese banks continue to trade at very undemanding price-to-book multiples of just 1.06 times.

Based on the strong correlation between ROEs (return on equity) and P/B (price to book) ratios for the top 100 global banks, the Chinese banks are trading at a sizable 50% discount to their global peers.

The low valuation tells us the market is pricing in a sustainable ROE of 9.4% for the Chinese banks. This is well below the 21.2% they reported in 2012. It is also below the 18.0% that the market expects from the group in 2014.

For the Chinese banks to achieve a 9.4% sustainable ROE, net interest margins would have to decline 90 basis points (one percentage point equals to 100 basis points) to 1.75%, or annual credit costs would have to rise 145bp to 1.90%. A combination of the two scenarios would also suffice.

These scenarios imply that the Chinese banks’ risk-adjusted net interest margins will fall to 1.40%, lower than most major countries in the world, even the over-banked Taiwan.

We forecast the banks will face a 30 basis points decline to their net interest margins and a 40 basis points increase to credit costs from current levels to sustainable levels where they will generate 14% to 15% ROEs.

Another explanation for the low valuations is that the market believes the book value of the Chinese banks is inflated by 50%. The market is pricing in a scenario where the Chinese banks’ book value is half of its reported value.

For this to occur, 15% of the banks’ loan books would have to deteriorate into non-performing loans immediately.

Our forecast is that the Chinese banks will face non-performing loan formation of 9% (cumulatively) over the coming 3 to 4 years, much lower than the scenario currently being priced into the Chinese banks.

As a result, we view the valuation of the group as attractive and prefer the large banks.

(The article has been edited for clarity)