I’ll take a shot at answering this. I have taken the liberty to split this into 3 sub-questions.
How to analyse a NBFC’s P&L?
NBFCs have the following headers in their profit & loss statement.
Revenue: Simply put, NBFCs borrow money from one place, lend it to people/businesses at a higher rate. So the revenue is simply lending rate (also called portfolio yield) multiplied by the size of the loan book (AUM - Assets Under Management). There are other sources of income like fee based income (loan processing fees etc) but these are typically very small as compared to interest based income. So we will ignore fee based income for now.
Cost of Funds: The borrowing cost of the NBFC. This is the interest that NBFCs pay to their lenders. Self explanatory.
OPEX: The operating expenses like salary, rental expenses, electricity, equipment, IT expenses etc. Straightforward.
Provisions: NBFCs have to account for some part of bad loans in their P&L statement. Since the cash flow for a bad loan has already happened, the loss needs to be spread out over time.
Taxes: Straight Forward.
Net Profit = Revenue - All Expenses
Return on Assets (RoA) = Net Profit/AUM
Return on Equity (RoE) = Net Profit/Shareholder's Equity
Lets look at the cost structure of some common NBFC assets classes
| | MicroFinance | Gold Loan NBFCs | HFCs | Bajaj Finance |
|--------------------|--------------|-----------------|-------|---------------|
| Portfolio Yield | 25.0% | 22.0% | 12.0% | 18.9% |
| CoF | 13.0% | 12.0% | 9.0% | 9.7% |
| OPEX | 7.0% | 7.0% | 1.0% | 5.0% |
| Provisions + Taxes | 1% | 1% | 1% | 1% |
| RoA | 4.0% | 2.6% | 1.8% | 3.1% |
Note: These numbers are a bit old and may not be very accurate. They are only here for illustration purposes.
As a rule of thumb: OPEX as a % of AUM is higher for lower ticket & shorter tenure loans.
Microfinance & gold loan NBFCs have higher portfolio yields but also higher OPEX due to their personnel and branch intensive operations. Housing Finance Companies (HFCs) have typically higher ticket sizes, much longer tenures (20 years), their scale of operations is very large and hence their OPEX as a % of AUM is very low. But they also have lower portfolio yields.
What are the right metrics to value NBFCs?
There is no single metric, you have to look at a combination of metrics. Traditionally people have used the following metrics to value NBFCs.
Return on Assets (RoA): This ratio tells you how efficient the NBFC is in its operations & fund raising. The higher the better and as you have seen above this differs by asset class. You cannot compare a microfinance NBFC’s RoA to a Housing Finance Company’s RoA.
Return on Equity (RoE): This ratio tells you how well the NBFC generates a return on share holder’s equity. The higher the better. This can be compared across different asset classes. Above 20% is considered to be really good.
Price to Book (P/B): Simply put its the ratio of market cap to its book value (~ shareholder’s equity). This ratio tells you how expensively or cheaply its valued by the market. Lower P/B might mean that the NBFC is undervalued. This needs to be looked at in conjunction with RoA and RoE.
But I like to dig in a little deeper and look at the following metrics:
Spread: The difference between the NBFC’s average lending rate and its cost of funds. This could be higher because of its assets class (Microfinance,gold loans etc) or due to management’s ability to raise funds at a lower cost (Bajaj Finance). Essentially how risky do the NBFC’s lenders consider it to be.
OPEX: OPEX as a % of AUM tells you how well managed & efficient NBFC’s operations are.
Gross NPAs: This tells you how well managed the loan book is. More specifically, how robust are the NBFC’s lending criteria and how tight are it’s loan recovery mechanisms. For some asset classes like microfinance, this could be higher due to the nature of its target customer base. So its not fair to compare across asset classes. However this should be as low as possible. Anything around 1% is considered good.
Growth in AUM: At the end of the day every business needs to grow for its value to appreciate. This growth rate can be compared with other companies. Anything above 15% is considered very good.
The reason Bajaj Finance is a favorite of investors because it has a high spreads, relatively low OPEX, low NPAs and its loan book has been growing consistently.
Why the Cash Flow Statement of NBFCs differs to other companies?
Usually for other companies having a positive cash flow from operations is considered good. But if you think about how an NBFC operates, its operations includes giving out loans. So its cash flow from operations is always going to be negative. And usually for other companies having a negative cash flow from financing activities is considered good because this indicates that the company is paying back its loans. But NBFCs need to raise debt to increase the size of their loan book. Hence their cash flow from financing activity is always going to be positive.
How do NBFCs grow?
As mentioned above, NBFCs grow their loan book by raising more debt. However NBFCs cannot go on indiscriminately grow their debt due to RBI’s Capital to Risk-weighted Assets Ratio (CRAR) guidelines.
CRAR = Total Equity / Risk Weighted Assets (RWA)
NBFCs are required to maintain a minimum CRAR. This means that if the NBFC increases the debt, the denominator in the above equation increases. NBFCs increase their numerator by retained earnings. But sometimes to counter the increased denominator NBFCs some times have to issue additional equity.
These are my 2 cents. Would like to get other experienced member’s take on this.