This is how the conversation went and it is purely imaginary.
Investor: I just bought a chunk of Yes Bank shares today and am sitting on a neat profit. Do you think it is a good stock?
Equity Advisor: You are asking me for advice after you have bought the stock. How does it make a difference anyways?
Investor: I still need you to ratify if my stock pick is right or wrong. I seriously trust your judgement.
Equity Advisor: OK, let me start with a question; why did you buy the stock? Was it as an investment or as a short term trade?
Investor: Actually, I bought it because it was moving up, but now I am planning to hold it for the long term. If the stock revives with the help of all other banks, it could be a great multi-bagger in the next few years.
Equity Advisor: So you expect Yes Bank to eventually become extremely profitable like HDFC Bank? I am not saying immediately but over the next few 15-20 years. Is that right?
Investor: Actually, that would be great. I think even if this bank can achieve half of what HDFC Bank has done in the last 25 years, I would be very happy.
Equity Advisor: OK, then we start with the assumption that Yes Bank will turn around and become another HDFC Bank in the next 25 years because that is the time that even HDFC Bank took to reach the current level. Can we start with that optimistic assumption?
Investor: Sounds too good to hear but let us go with that. I am already salivating.
Equity Advisor: OK, now let us get down to some hard numbers. Let us start with the net profit of HDFC Bank for the fiscal year 2019. It was a shade above Rs21,000cr. This was achieved on outstanding share capital of 272 crore shares. That gives you an EPS (earnings per share) of Rs77.
Investor: Now you are getting into valuation game with me. The EPS is Rs77 and the current market price is Rs1000 so the P/E ratio is around 13X. Is that what you are getting at?
Equity advisor: I am actually going a little beyond that. I will now draw an analogy with Yes Bank. Do you know the share capital of Yes Bank after the RBI reconstructed the bank?
Investor: No, actually I never bothered to look into those details.
Equity Advisor: OK, here it is. Yes Bank will have 3000cr shares of face value Rs2 each. If you compare with HDFC Bank, then the Yes Bank’s capital size is 11 times that of HDFC Bank.
Investor: That is fine; but how does that impact my decision to buy Yes Bank.
Equity Investor: Let us get back to our discussion of Yes Bank becoming an HDFC Bank in the next 25 years. Assuming that Yes Bank does not dilute its equity in the next 25 years (highly unlikely), we would have Rs21,000cr profit in Yes Bank after 25 years. At that point the EPS of
Yes Bank will be Rs7.
Investor: Now, what you are saying is that after 25 years, Yes Bank will have EPS of Rs7 so applying HDFC Bank’s P/E of 13, we get a price of Rs91?
Equity Investor: I will not be so miserly. I will allow you to put a P/E ratio of 20 because currently most banks are quoting at very low P/E ratios. If you apply P/E of 20, then Yes Bank should be worth Rs140 after 25 years.
Investor: That is still good. I bought at Rs34, so Rs140 is my target.
Equity Advisor: It is not that simple. Rs140 is the value after 25 years. You need to look at what would be the value today?
Investor: But how can I figure that out?
Equity Advisor: Let us take a simple approach. You can get 12-13% annually on the Nifty. So obviously you want to make more on Yes Bank due to the risk. Let us say you want to earn 15% each year.
Investor: I think that is fair calculation. So what?
Equity Advisor: If Yes Bank stock has to compound at 15% over 25 years to reach Rs140 value, what should it be worth today. Compounding is much easier with an excel sheet and a simple iteration. If you apply the basic compounding you will figure out that Rs4.25 today will grow at 15% to Rs140 after 25 years.
Investor: Hold on; are you saying that Yes Bank is worth Rs4.25 today. Jesus! That was approximately the low that the stock hit on the day of the price crash.
Equity advisor: I think you are reading too much into my statements. My only suggestion is to do a lot more homework in case you are looking to hold a stock for the long run.