For most companies, investors tend to focus on the price-to-earnings (PE) ratio. For banks, the price-to-book (PB) ratio is often more useful.
Why? A bank's balance sheet is its business. It takes deposits, lends money and earns a return on the capital it holds. That makes book value an important measure for shareholders.
But PB should not be viewed in isolation. A bank can command a higher PB if it generates a higher return on equity (ROE) and grows its book value at a healthy pace.
This is why a bank trading at 2 times book is not necessarily expensive. If it can consistently generate a high RoE, investors may be willing to pay that premium.
The reverse is also true. A bank trading at 1.5 times book may appear cheap. But if its ROE has fallen sharply, the lower valuation may simply reflect weaker earning power.
So, is HDFC Bank cheap today?
We look at its PB against historical levels, compare it with other large banks and assess whether its current ROE supports the valuation. The PE ratio provides a secondary check.
These are only a few measures of valuation, and valuation is not an exact science.
HDFC Bank's stock trades at roughly 1.8 times book value. That is a significant change from the valuation investors were once willing to pay for the bank.
HDFC Bank traditionally commanded a premium because of its strong asset quality, large deposit franchise and ability to generate healthy returns on equity. Today, the market is assigning it a much lower multiple. The valuation has clearly de-rated.
But does that automatically make the stock undervalued?
Not quite. The key question is how much return the bank can generate on its book value.
The missing piece is ROE
This is where PB becomes more useful.
Imagine two banks, each with ₹100 of book value. One earns ₹18 a year, while the other earns ₹10. Would you pay the same price for both?
Probably not.
The first bank generates an 18% ROE, while the second earns 10%. The first can therefore justify a higher PB.
That is the key issue for HDFC Bank today. Its return on equity has declined.
HDFC Bank reported ROE of 13.8% in the June quarter, compared with 14.1% in the March quarter. Return on assets also declined to 1.85% from 1.96%.
These are still respectable numbers. But they are below the levels investors had become accustomed to from HDFC Bank.
That matters because the bank's earlier premium valuation was based partly on the expectation that it could continue generating superior returns.
The market is now asking a different question: Can HDFC Bank get its ROE back to 15% or higher?
If it can, the current PB could look attractive. If ROE settles closer to 13-14%, the lower multiple may be justified.
That is perhaps the most important metric to watch.
Valuation compared with peers
HDFC Bank trades at 1.8 times book, almost the same as Axis Bank at 1.8 times. It is below ICICI Bank at 2.7 times and Kotak Mahindra Bank at 2.2 times.
The comparison with ICICI Bank is particularly interesting. ICICI Bank commands a much higher PB and also has a higher ROE—15% compared with 13.1% for HDFC Bank.
So, the valuation gap is not entirely unexplained.
ICICI Bank is currently generating better returns, and HDFC Bank needs to show that it can close that gap. At the same time, HDFC Bank's valuation is not particularly high compared with other large-cap banks. Its PB is closer to Axis Bank's than to the premium valuations of ICICI Bank and Kotak Mahindra Bank.
What does the PE ratio say?
PB gives us the main picture. PE provides another useful check.
HDFC Bank trades at around 13.2 times earnings, below ICICI Bank at around 16.7 times and Kotak Mahindra Bank at around 20.5 times. Axis Bank trades at around 14 times.
The PE ratio tells a similar story. HDFC Bank is no longer receiving the premium valuation it enjoyed in the past. But, again, there is a reason for the discount.
Profit growth has been modest, margins have come under pressure and investors are waiting for the post-merger bank to deliver better returns.
That brings us to the latest results.
Q1 FY27: Loan growth is healthy, but margins remain under pressure
HDFC Bank's June quarter showed that the balance sheet is still growing.
Gross advances grew 15.4% year-on-year, while deposits also grew at a healthy pace.
That is encouraging. The problem is profitability.
Net interest margin (NIM) fell to 3.26% from 3.38% in the March quarter. Return on assets declined to 1.85%, while ROE came in at 13.8%.
The bank's profit after tax was ₹190.6 billion in the June quarter.
So, this is not a story of a bank whose business has stopped growing. It is a story of a bank that is growing its balance sheet but is not yet generating the level of returns investors want to see.
That distinction is important.
There is another reason for the valuation discount
HDFC Bank is also heading towards a planned leadership transition.
Managing director and chief executive Sashidhar Jagdishan has confirmed that he will retire at the close of his Reserve Bank of India-approved term on 26 October 2026, choosing not to seek reappointment.
While the board has fast-tracked the selection process for a successor, leadership transitions can create a wait-and-watch sentiment among institutional investors.
Investors were willing to pay more for HDFC Bank when they had greater confidence in its growth, profitability and leadership. The market may be waiting for more clarity before assigning the bank its earlier valuation premium.
That does not necessarily change the long-term investment case. But it is one factor that could keep the stock's valuation subdued in the near term.
Conclusion
So, is HDFC Bank stock undervalued?
On PB, it certainly looks more attractive than it has in the past.
The stock trades at around 1.8 times book value, a sharp discount to the premium valuation HDFC Bank commanded in earlier years. It also trades below the PB multiples of ICICI Bank and Kotak Mahindra Bank.
But there is a reason for that discount. HDFC Bank's ROE has fallen to 13.8%, NIM is under pressure and the bank is going through a leadership transition.
The real question, therefore, is not whether HDFC Bank is cheap compared with its old valuation. It is whether the bank can improve its return on equity from here.
If ROE moves back towards 15% and beyond, the current PB could prove low. If returns remain around current levels, the market may have already adjusted the valuation to reflect the new reality.
The recovery in returns is what investors need to watch.
Investors should evaluate the company's fundamentals, corporate governance and valuation as part of their due diligence before making investment decisions.
Happy investing.
Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.
This article is syndicated from Equitymaster.com