The EV/EBIDTA malaise for Indian banking.

The Indian banking industry especially the PSU banks have been in the news for the higher NPA
provisions this quarter in lieu of RBI diktat to clean their books by March 2017. As it stands, the finance
ministry would have to commit a significantly higher amount of capital to ensure these banks start
growing again.
An analysis of how the banks reached this situation can be many, delayed economic turnaround, flawed
business models, policy issues etc. However a significant amount of blame needs to put on the doors of
the intelligent traders, investors and analysts at Dalal Street and of course the bankers looking at market
capitalization to determine the equity position of the company
The EV/EBIDTA model of valuation has been a globally accepted norm since it takes into account the
debt of the company and gives a more accurate picture than the conventional PE ratio. As companies
market capitalization started to move north, more and more companies with heavy fixed assets found a
very unique way to increase their share prices. The solution lied in taking more debt, increasing the
EBIDTA and consequently the Bull Run on the stock.
A simple illustration, if a companys EV is Rs 100; EBIDTA is Rs 20, the EV/EBIDTA multiple stands at 5. In
the following year the company takes a debt of Rs 40 and increases EBIDTA by Rs 10. the EV/multiple
reduced to 4.66, leaving space for the share prices to improve using peer comparison formulas.
This gave rise a complex chain reaction, where debt increased share prices and with higher valuations,
banks could lend more considering higher equity and the party went on.
The debt cycle helped the companies improve its share valuation to an extent. However after a couple
of years, the principal and interest payments started burdening the companies with liquidity issues.
Dalal street has been very prompt is rerating these companies downwards to include the heavy debt
and the consequent existential threat these companies face in the medium term
But the banks have nowhere to go. They are stuck with companies with low share prices, limited cash
flow to service debt and limited acquirers for the lemons.
As the PSU banks survive this tumultuous cycle, it is hoped that the government and RBI will force upon
the banks management to change their risk appraising process to ignore the EV/EBIDTA ratio or the
share market valuations to arrive at the amount of debt eligibility. This may hamper growth in the short
run but would help the financial industry be healthier state than today.

Smitesh Aravind