- I am first and foremost a value investor. When growth has outperformed value for an extended period of time, as is the case today, I look at growth. Not to buy, but to identify good stocks, appreciated by market participants, and which might during a period of market stress, or a period when value outperforms growth, represent good value.

**Source:***Yahoo Finance.*

In the recent past I have looked at Google (NASDAQ:GOOG), Tesla (NASDAQ:TSLA), Amazon (NASDAQ:AMZN), and Facebook (NASDAQ:FB), with optimism in the outlook, and pessimism in valuation. I own none of these stocks today, and what I am doing is building a watch-list of interesting names to own, should the opportunity present itself: one day, if ever.

Today growth stocks are very fully valued in the U.S. markets. But that is not the case in every market in the world, where there is a wide selection of growth available at a very reasonable price. Today I am looking at HDFC Bank (NYSE:HDB). And for a change, I do own it, though I own the ordinary shares listed in India, three of which make up one ADS listed in U.S.

**Who is HDFC Bank?**

HDFC Bank is the largest private sector bank in India by market capitalization, closely followed by ICICI Bank. The bank was promoted by HDFC, a housing finance company, in 1994, and started operations in 1995. It was the first private sector bank that came into being post policy liberalization. Since then it has grown in leaps and bounds, running circles around inefficient public sector banking competitors, and the more efficient foreign banks.

Today HDFC owns 22.69% of HDFC Bank. A further 34.92% is owned by foreign institutional investors, 9.27% by Indian institutional investors, 17% is owned by owners of foreign listed ADS and ADRs and 16.12% is owned by non-institutional investors. The ownership quality is solid. In terms of market capitalization, HDFC Bank is best classified as a large capitalization company: it has a free float market capitalization of near $20 billion and a total market capitalization of near $25 billion. In terms of index influence, HDFC Bank, with a weightage of 6% to 7% on the Sensex and NIFTY, is an influential stock.

In terms of value, HDFC Bank trades at a multiple of 18.6 times earnings estimated for the year ended 31 March 2014, and 15.2 times earnings estimated for the year ended 31 March 2015. This compares with the Sensex trading at a multiple of 15.9 times earnings estimated for the year ended 31 March 2014, and 13.6 times earnings estimated for the year ended 31 March 2015. HDFC Bank comes with a beta of 1 versus the Sensex. One might argue that it is more expensive than the market, and thus not a buy. However, HDFC Bank deserves its premium to market multiple. After all, during the past six years, Sensex has delivered nominal annualized earnings growth of near 8%, while HDFC Bank has delivered nominal annualized earnings growth of near 30% during the same period. That must count for something.

The growth opportunity ahead remains large. India is a vastly under-banked country, with a surprisingly small proportion of adults having access to banking. The government and the Central Bank are both encouraging growth and financial inclusion, and so the financial services sector has a policy tail-wind behind it.

Banking faces Consumers, Industry, Services and Agriculture. It faces rural India as well as urban India. Thus banking is an easy way to invest in the India growth story. Banking is also a highly cyclical and rate sensitive sector. That is a big positive if we are nearing the bottom of the economic cycle and a peak in the interest rate cycle. And as I mentioned in a recent post (There Is Beauty In The Ugly Indian Economy), in my view, the economic cycle is due to bottom and shift into growth mode. In addition, with real interest rates on the ten year government securities adjusted for inflation at 3.5%, compared with a 1.08% average over ten years, and a forward real rate expectation of 2%, it does look like India is past a peak in the interest rate cycle. A bottom in the economic cycle and a peak in the interest rate cycle would be a powerful catalyst for the financial services sector.

As far as price is concerned, HDFC Bank hit a 52 week low at Rupees [Rs] 528 per share on August 28, 2013. And it hit a 52 week high of Rs 727 on May 30, 2013. It closed on February 21, 2014 at near Rs 665. If India's growth cycle does resume, the stock would have a long way to climb over the coming three to five years.

ICICI Bank (NYSE:IBN) is better valued and has similar growth opportunity. Yes Bank, IndusInd Bank and Kotak Bank (OTC:KMBKY), are smaller, and offer a better growth opportunity. All the aforesaid stocks come with high betas: they come with high return potential, but with higher perceived risk. In my view, HDFC Bank, with its low beta, provides the best mix between quality and growth: it has a commendable track record, and an exceptionally strong well capitalized balance sheet.

Let's try and figure what HDFC Bank is worth. And what return potential it offers.

In looking at what HDFC Bank might be worth, I believe it is most appropriate to base expectations on Rupee performance, for that is the functional currency of the business. In the table included in the next section of this post, I display past performance and use it as a means to project future expectations.

For those who are interested, I have added two tables at the end of this post: the first adjusts the historic nominal Rupee data for inflation using the Wholesale Price Index as at March 31st at each fiscal year end. This allows a view into how HDFC has grown its business in real terms. The second table adjusts the historic nominal Rupee data to the Dollar using exchange rates as at March 31st at each fiscal year end: in this table, the EPS amount is multiplied by 3 so that it reflects an approximation of per ADS earnings. This allows people to view how HDFC Bank has grown its earnings despite the near catastrophic decline in Rupee value since 2002.

**Past Performance as an indicator of future growth potential**

In the table below you will see revenue and fully diluted earnings per share [EPS] data since the year ended March 31, 2002.

The columns labeled Revenue Growth and EPS growth display year-on-year growth for revenue and EPS respectively.

The columns labeled 6Y Rev Growth and 6Y EPS Growth display annualized growth rates for revenue and EPS over the last six years respectively.

The columns labeled EPS6 and EPS6 Growth display the six year median EPS, and the year-on-year growth in six year median EPS respectively.

These numbers are in Millions of Rupees, except for per share amounts. The per share amount prior to 2011 are split adjusted for the 1:5 share split in April 2011. Keep in mind that 3 shares equal 1 ADS.

**Source:***Revenue and EPS data for 2002-2013 is from Sec Form 20F filings available* *here**. For 2014, I have used Reuters Consensus data available* *here**. All other data is my analysis of revenue and EPS data.*

Barring the dip in 2008 and 2009, which was an ugly period globally, HDFC Bank has grown earnings at a healthy clip, averaging annual growth of 33.65% for revenue and 27.24% for EPS since 2002.

Looking at annualized growth rates over a six year period, gives us a better feel how revenue and EPS has grown over the course of a typical economic cycle. Here too we see impressive revenue and EPS growth at annualized rates of 35.21% and 23.98% respectively.

EPS6 is a measure I use to see how median six year EPS is growing over time. This too displays strong average growth of 26.46%.

History doesn't repeat, but it often rhymes. For the year ending March 31, 2015, Reuters consensus data indicates sales growth of 19.57%, EPS growth of 22.91% and a long-term EPS growth rate of 26.51%.

**Source:***Reuters Consensus data available* *here**.*

In my view, the estimates for the year ending March 31, 2015 are relatively conservative. I will be looking for closer to 24% EPS growth. On the other hand, the long-term growth rate may be a bit on the aggressive side: while the growth opportunity is large, HDFC Bank's size can be expected to make growth harder. In addition, new competition through the issuance of new banking licenses by the Central Bank can be expected to increase competition. I am looking for forward growth of 23.5% over the coming five to six years.

**The Growth Multiple**

I did a recent post on the Math of the Market Multiple, which you can read here. I strongly recommend that you read it, because if you don't, I might lose you as we proceed through this part of the post: in many ways, this is a direct continuation of that post. I had ended that post saying:

"Look at the mathematical expression: $1 * (1 + G%) * (1 - Rr)/(VLT ERP + Rf - G%). We know that VLT ERP + Rf is the market return expectation. What would we do if the market return expectation was lower than or equal to growth? We get either an incoherent or an insolvable value!

Approaching growth multiples is different, and I'll get into it in a post another day. We have all seen situations where buying a high multiple paid out manifold, as well as situations where buying a high multiple ended in tears. What occurs is not a result of the multiple: the multiple simply is what it is. The outcome is influenced by the accuracy of the various estimates included in the components of the multiple.

Working through the math of the multiple gives you a better chance of seeing whether today's high multiple, will become a lower multiple and a profitable investment tomorrow."

In the above extract:

G% means the growth rate to perpetuity

Rr is the reinvestment rate, which can be calculated as G% divided by the return on equity (RoE%)

(1-Rr) is the notional payout [NP]

VLT ERP is the very long-term equity risk premium which is calculated as Beta * (Rm - Rf)

Rm is the market return expectation

Rf is the risk free rate

VLT ERP + Rf is equal to Rm

History tells us that the market exists for a period of sufficient duration to consider perpetual existence. This presumption of perpetuity does not hold true for stocks. When considering individual companies, stock selection, diversification and valuation are our friends.

With HDFC Bank, I am reasonably confident that we have a residual life which will be sufficiently long to consider perpetual. But I would not consider owning HDFC Bank as the only stock in my portfolio: I'd certainly want diversification. And I'd want to own it at a good price.

**What does the math of the present multiple imply?**

Rs 1 * (1 + G%) * (1 - Rr)/(VLT ERP + Rf - G%) calculates present value of future cash flows an investor can expect to receive from each Rupee of earnings. It is the multiple of earnings a person with certain expectations should be willing to pay. This can also be expressed as $1 * (1 + G%) * NP/(Rm - G%).

The return on equity for HDFC Bank is about 18.5%. For a market return expectation, I will work with 15.5%, made up of an 8% long-term risk free rate and a 7.5% long-term equity risk premium.

With HDFC Bank trading at near Rs 665, it is trading at a multiple of 18.65 times March 2014 earnings. What growth to perpetuity and notional payout does that imply for a person with a return expectation of 15.5%, and a long-term return on equity expectation of 18.5%?

An investor with a return expectation of 15.5% should be willing to accept a multiple of 18.65 times earnings, for a stock with a notional payout of 24.22%, and growth in perpetuity of 14.02%.

A perpetual growth rate of 14.02% would imply a notional payout of 24.22% (1 - 14.02%/18.5%) assuming a return on equity of 18.5%. The multiple is calculated as $1 * (1 + G%) * NP/(Rm - G%). Thus if G% is 14.02%, RoE% is 18.5%, NP is 24.22%, and Rm is 15.5%, the multiple is 18.65 ($1*114.02%*24.22%/(15.5% - 14.02%).

A growth rate of 14.02% does not seem much of a challenge for a company like HDFC Bank. This growth rate is in line market growth expectations of 14.3%, made up of potential GDP growth of 7.8% (10 year average real GDP growth rate) and inflation of 6.5% (10 year average inflation rate).

Thus on the face of it, HDFC Bank offers good value at the current price of Rs 663. And there is plenty of scope for upside from stock earnings growth at a higher level than market earnings growth.

**HDFC Bank Alpha Potential**

*What is Alpha?*

The underlying principle is the recognition that investor returns and risk are directly related. Returns reward risk takers. An investor's return and return expectation is based on risk associated with an investment. Alpha can be positive or negative, though when we seek Alpha, be assured that we are seeking a positive Alpha! Alpha is created when the return from an investment is higher than the risk adjusted return which should have been earned from the investment. Seeking Alpha is the art of stock selection, where efforts are made to identify stocks which will generate higher actual returns, compared with the risk adjusted returns which should have been earned after considering the risk of the investment relative to the market.

*Mathematically Alpha can be expressed as:*

Alpha = Ri - [Rf + β * (Rm-Rf)], where Ri is the return generated by the investment, Rf is the risk free rate, Rm is the market return, and β is a measure of risk of an investment relative to the market.

HDFC Bank has a beta of 1 versus the Sensex. Thus the capital asset pricing model suggests that investors should expect a return consistent with the market. I am using a market return expectation of 15.5%, made up of an 8% long-term risk free rate and a 7.5% long-term equity risk premium, and since HDFC Bank has a beta of 1 versus the Sensex, that is the return I should expect from HDFC Bank.

In my view valuing optimistic expectations over the reasonably foreseeable period, and valuing the period beyond in-line with broad markets is acceptable. For HDFC Bank, I will use Reuters consensus estimates for the year end March 31, 2015 of Rs 43.83 and my estimate of a five year earnings growth rate of 23.5% for the four years following the year ended March 31, 2015. Using this projection, in five years, by March 31, 2019, earnings at HDFC Bank would be Rs 101.96 (Rs 43.83 * 1.23^4).

Growth in line with market growth of 14%, a return on equity of 18.5% and a market return expectation of 15.5%, would imply a multiple of 18.5, and a March 2019 price and value target of Rs 1,886. With the share price at Rs 665 at present, a target of Rs 1,885 in 2019 implies an annualized return of 22.7% over the coming 5.09 years. With an expected return of 15.5% from both the stock and the market, a 22.7% return, if achieved, provides 7.2% in annualized alpha. That is a lot of alpha.

**What about Dollar returns**

A person investing in Dollars faces currency risk. The ADS is valued based on the underlying ordinary shares, which operate in a Rupee functional environment.

Where will the Rupee be in 2019 March? The way I see it, the Rupee is rightly valued at about Rs 59 to $1 today. With a resumption of the growth cycle, I expect this level very quick, on capital inflows. Without a resumption of the growth cycle, the Rupee will stay weak. From this value, because of inflation differentials adjusted for total factor productivity, we can expect an annualized depreciation in the Rupee of 2%. Thus by March 2019, the Rupee would be rightly valued at Rs 65.26 to $1.

The ordinary share price or value target of Rs 1,886 implies a price or value target of Rs 5,658 per ADS or $86.70 when translated at Rs 65.26 to $1. The HDFC Bank ADS recently traded at $33.03, which implies an annualized return potential of 20.85% over the coming 5.09 years. A person seeking no currency risk has the option of sacrificing part of the return potential, to hedge the currency risk.

Let me conclude by saying that this post is not a recommendation of any sort. Nor is it research. Nor can it be considered due diligence. It is merely an idea, or an investment thought-piece: if you like, it is a penny for my thoughts! I'd be delighted if you enjoyed it and it got you thinking, but if you buy, or if you sell, be sure to do your homework, research and due diligence first. If you did not like the post, or the thought of HDFC Bank representing what might be an interesting buy pick that is fine too. There are two sides to every trade. We need a seller and buyer for the two parties to walk away satisfied: if you are a seller of HDFC Bank, be glad that there are buyers available.

## Additional Data

**HDFC Bank Performance History Adjusted for Inflation**

**Source:***Revenue and EPS data for 2002-2013 is from Sec Form 20F filings available* *here**. For 2014, I have used Reuters Consensus data available* *here**. This data has been adjusted to real terms using the wholesale price index level at 31 March each year. All other data is my analysis of revenue and EPS data.*

**HDFC Bank Performance History Presented in $ (EPS in $ Per ADS)**

**Source:***Revenue and EPS data for 2002-2013 is from Sec Form 20F filings available* *here**. For 2014, I have used Reuters Consensus data available* *here**. This data has been adjusted to $ terms using the exchange rate on 31 March each year. Earnings data is per ADS (3 Ordinary Shares = 1 ADS). All other data is my analysis of revenue and EPS data.*

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