Non-banking finance companies (NBFCs) form an integral part of the Indian financial system. They play an important role by complementing the banking sector in reaching out credit to the unbanked segments of society, especially to the micro, small and medium enterprises (MSMEs), which form the base of entrepreneurship and innovation. The role of NBFCs becomes even more important now, especially when the government has a strong focus on promoting entrepreneurship so that India can emerge as a country of job creators instead of being one of job seekers.
The NBFC sector in India has undergone a significant transformation over the past few years. The success of NBFCs can be clearly attributed to their better product lines, lower cost, wider and effective reach, strong risk management capabilities to check and control bad debts, and better understanding of their customer segments.
NBFCs are certainly emerging as better alternatives to the conventional banks for meeting the financial needs of various sectors. However, to survive and to constantly grow, NBFCs have to focus on their core strengths while improving on weaknesses. They will have to be very dynamic and constantly endeavour to search for new products and services in order to survive in this ever-competitive financial market.
Evaluating NBFCs is a different ballgame altogether as NBFCs are different from manufacturing companies. There is no single metric for evaluation, you have to look at a combination. Traditionally people have used the following metrics to value NBFCs.
- Return on Assets (RoA) v/s Return on Equity (RoE): RoA ratio tells you how efficient the NBFC is in its operations & fund raising. The higher the RoA, the better, though it can depend on the asset class. RoE 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 it is the ratio of market cap to its book value (shareholder’s equity). This ratio tells you how expensively or cheaply it’s 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.
- Spread: This is the difference between the NBFC’s average lending rate and its cost of funds. This could be higher because of its assets class or due to management’s ability to raise funds at a lower cost. Higher the operating cost, lower the spread.
- OPEX & Growth in AUM: Operating Expenses (OPEX) as a % of AUM tells you how well managed & efficient NBFC’s operations are. 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.
- 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 its loan recovery mechanisms. Though it’s not fair to compare across asset classes, this should be as low as possible. Anything around 1% is considered good.
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