Estimating the Intrinsic Value, Return on Investment and Margin of Safety of Chongqing Rural Commercial Bank using the Dividend Discount Model

Summary

This article looks at the valuation of Chongqing Rural Commercial Bank shares listed on the Stock Exchange of Hong Kong (Ticker: 03618.HK). The Dividend Discount Model is used to estimate the share's Intrinsic Value, Expected Return on Investment, and its Margin of Safety.

Introduction to Chongqing Rural Commercial Bank

Chongqing Rural Commercial Bank Co., Ltd., formerly Chongqing Rural Credit Cooperative, was founded in 1951 and has a 70-year history. Chongqing was selected as one of the first batch of pilot provinces and cities for the nationwide rural credit cooperative reform in 2003.

The rural commercial bank was established in 2008 as a limited liability joint stock company to acquire all assets and liabilities of 38 County (District) Rural Credit Cooperative Unions.

The bank's H-share was successfully listed on the Main Board of the Hong Kong Stock Exchange in 2010, making it the first listed rural commercial bank in China as well as the first listed bank in western China.

The bank successfully listed on the main board of the Shanghai Stock Exchange in 2019, becoming China's first rural commercial bank with A+H dual listing and the first bank with A+H dual listing in western China.

The main businesses of the bank are corporate finance, inclusive finance, retail finance, and financial markets:

• The corporate finance business primarily offers a wide range of corporate finance products and services to businesses and public institutions, government agencies, and financial institutions, such as corporate loans and deposits, trade financing loans, bills, and guarantees.
• The primary business of Inclusive Finance is to provide financial services to new agricultural business entities such as small and micro enterprises, farmers, and farmers' professional cooperatives.
• The retail finance business consists of personal loan and deposit business, bank card business, and intermediary business.
• The financial market business consists primarily of capital operation, investment banking, and asset custody.

Dividend Discount Model

The Dividend Discount Model is one of several methods for determining stock value. The procedure is similar to the Discounted Cash Flow model, except that dividends are substituted for free cash flow as the cash flowing to the investor. One advantage of this method is that dividend information is easily accessible from the company's financial reports. It is also my preferred method for valuing dividend-paying stocks. Dividends are tangible income for the investor and represent the return of investment and return on investment. Dividend cash allows the investor to reinvest the proceeds in the same stock or in other more appealing stocks, achieving the all-important compounding effect.

This article describes the use of the Dividend Discount Model to determine the Intrinsic Value, Expected Return on Investment, and Margin of Safety of Chongqing Rural Commercial Bank (03618.HK) shares listed on the Stock Exchange of Hong Kong.

Chongqing Rural Commerical Bank's Dividend and Earnings Track Record for FY2011 to FY2021

The table above summarises the bank's historical earnings per share and dividends per share from FY2011 to FY2021, based on data from its Annual Reports. It is worth noting the following:

1. The compounded annual growth rate (CAGR) of shareholder equity was 11.48%.
2. The compounded annual growth rate (CAGR) of basic earnings per share (EPS) was 6.21%.
3. The compounded annual growth rate (CAGR) of dividend per share (DPS) was 6.08%.

Chongqing Rural Commercial Bank has a consistent track record of growing its dividends, earnings and shareholder equity. However, past performance is not necessarily indicative of future performance.

Does Chongqing Rural Commercial Bank (03618.HK) currently offer an attractive dividend yield (above the average yield of Hang Seng Index constituents)?

For FY2021, Chongqing Rural Commercial Bank declared dividends of 0.2966HK$ per ordinary share. On 12th October 2022, the bank's H-share closed at 2.54HK$ per share. This translates into a dividend yield of 11.68%, significantly higher than the average dividend yield of the constituent stocks of the Hang Seng Index, which is approximately 6.61% according to AAStocks.

Data Source: AAStocks.com

Is Chongqing Rural Commercial Bank's Dividend Payout considered sustainable?

Chongqing Rural Commercial Bank reported a net profit of 9,559.7 million RMB in FY2021 and paid out 2,868 million RMB in dividends. Its dividend payout is covered by net income 3.33 times. From FY2019 to FY2021, the average dividend coverage ratio was 3.47 times, which is considered safe or sustainable.

Capital Adequacy Ratio for Chongqing Rural Commercial Bank

As of 30 June 2022, the Bank's capital adequacy ratio indicators are reported as follows:

It is noted that Bank's Core Tier 1 capital adequacy ratio is 12.82%, providing a comfortable capital buffer of 4.32% above the minimum CET1 ratio of 8.5% for D-SIBs.

10 year Dividend Discount Model for Chongqing Rural Commercial Bank

For the purpose of evaluating the investment worthiness of Chonqing Rural Commercial Bank, a discounted cash flow analysis (Dividend Discount Model) is used to determine a reasonable estimate of the Intrinsic Value, Expected Return on Investment and Margin of Safety of its H-shares. The following are the key parameters for the cash flow model:

Model Assumptions

The following assumptions were used in building up the Discounted Earnings Model for China Telecom.

• Beta = 1.05
• Market Risk Premium = 10.5% (Conservatively based on the MRP on November 2008)
• Risk Free Rate = 3.80% (Based on 10 year Hong Kong Govt Bond Yield on 13th October 2022)
• Expected Return on Capital Asset, Ke = 3.80% + 1.05 x 10.5% = 14.825%
• Time period = 10 years (From Fiscal Year 2022 to 2031)
• Annual EPS Growth Rate is modeled to decline gradually from 4.0% in 2022 to 3.1% in FY2031.  The resulting CAGR in earnings from FY2021 to FY2031 is 3.55%.
• The Dividends are modeled to grow at CAGR of 3.529% from FY2021 to FY2031, assuming the payout ratio of 30%.
• The Book Value per share is modeled to grow at CAGR of 6.122% from FY2021 to FY2031.
• The terminal value is estimated from the Price to Book Value using the equation below: 

• Sustainable growth rate = 3.0%.
• Quantity of ordinary shares (fully diluted) = 11,357 million.
• Currency exchange rate = 1.09HK$/RMB

The 10 year Dividend Discount Model is as shown below:

With reference to the summary table above, the following can be observed :

1. Based on a discount rate of 14.825%, the intrinsic value of the bank's H-share is estimated at 3.353HK$ per share. The margin of safety is 24.24% based on the closing price of 2.54HK$ on 12th October 2022.
2. Using the goal seek function of Excel, the discount rate which will yield an intrinsic value of 2.54HK$ is calculated to be 17.705%. This value of 17.705% is the Expected Return on Investment for Chongqing Rural Commercial Bank H-shares at a cost basis of 2.54HK$ per share, over a 10-year period.

How does Chongqing Rural Commercial Bank (03618.HK) measure against the Traditional Value Investing Benchmarks?

The Price to Earnings ratio and the Price to Book Value ratio are two popular yardsticks for determining the worth of stocks as investments. In this section, we will examine how Chongqing Rural Commercial Bank (03618.HK) compares to these benchmarks. Based on the share price of 2.54HK$ per share, the following observations are made:

• Trailing PE Ratio:  
  • EPS FY2021 = 0.84RMB = 0.9156HK$
  • PE = 2.54/0.9156 = 2.774
  • The price represents an opportunity to own a stake in the bank at a PE of less than 3.
• PBV Ratio:
  • Book Value FY2021 = 8.89RMB = 9.69HK$ per share
  • PBV = 2.54/9.69 = 0.262
  • The Return on Equity of Chongqing Rural Commercial Bank (03618.HK) in FY2021 is 9.80%. Using a discount rate of 14.825% and a perpetual growth rate of 3.0%, the expected PBV can be estimated to be 0.575. At a Price to Book Value of 0.262, the H-share is significantly undervalued.

Conclusion

In this article, I set out to document the rationale behind an investment decision to purchase Chongqing Rural Commercial Bank (03618.HK) shares trading on the Stock Exchange of Hong Kong.
Chongqing Rural Commercial Bank's intrinsic value is estimated to be 3.353HK$ based on a discount rate of 14.825%.
The share price of 2.54HK$ (closing price on 12th October 2022) provides a comfortable margin of safety of 24.24%.
Furthermore, at this price, the Expected Return on Investment is estimated to be 17.705%  per year, over a 10-year period.

Disclaimer:

This article is a record of the thinking behind a personal investment decision. It does not represent any recommendation to purchase any stock mentioned in the article. As always, readers are strongly advised to do their own due diligence before making any investment decisions.