Valuing the large China state-owned Banks using Gordon Growth Model
Introduction
The Gordon Growth Model, or GGM, is a valuation method for calculating the intrinsic value of a dividend-paying stock. The model is particularly suitable for valuing mature companies with stable operations and sustainable growth in dividends.
In this article, a valuation exercise is carried out using the GGM to estimate the intrinsic value of the large China state-owned banks trading on the Hong Kong Stock Exchange. These banks are mature financial institutions with stable operations and have exhibited consistent earnings and dividend growth throughout the years. Furthermore, they have consistent dividend policies, consistently paying out around 30% of their earnings as dividends every year.
Model Parameters
The following parameters are used for estimating the expected rate of return using the Capital Asset Pricing Model:
Rf = 10 year Hong Kong government bond yield = 4.40%.
RPm = Market Risk Premium for Hong Kong = 10.30% (This is a conservative number based on the MRP in November 2008, during the depths of the Global Financial Crisis.)
Beta = The Equity Beta as published on the Yahoo Finance website multiplied by a safety factor of 1.25.
The sustainable long-term growth rate (g) is estimated at 3%, a conservative estimate that matches the long-term inflation target for China.
The currency exchange rate is 1.06 HK$/CNY, a conservative estimate.
Sustainable Earnings Growth Rate (SEGR)
A company's sustainable earnings growth rate can be estimated from its dividend payout ratio (POR) and its return on equity (ROE).
The formula for calculating SEGR is as follows:
SEGR = (1-POR) x ROE
It is noted that the estimated SEGR for the banks is considerably higher than the 3% value adopted for the GGM calculation. Hence, the intrinsic value as estimated in this current exercise will, in all likelihood, underestimate the true value of the individual bank stocks.
Calculating the Intrinsic Values
The intrinsic value of each stock is calculated and tabulated below:
| Stock | Ticker | Stock Price (1st Nov 2023) | Intrinsic Value | Margin of Safety |
| Bank of China | 3988.HK | 2.77 HK$ | 3.755 HK$ | 26.22% |
| China Construction Bank | 939.HK | 4.47 HK$ | 5.440 HK$ | 17.83% |
| Industrial and Commercial Bank of China | 1398.HK | 3.80 HK$ | 5.155 HK$ | 26.28% |
| Agricultural Bank of China | 1288.HK | 2.91 HK$ | 3.903 HK$ | 25.44% |
| China Citic Bank | 998.HK | 3.50 HK$ | 4.664 HK$ | 24.96% |
| Chongqing Rural Commercial Bank | 3618.HK | 2.94 HK$ | 3.263 HK$ | 9.90% |
Comparing the intrinsic values of the bank stocks and their closing prices on November 1, 2023, it can be seen that these bank stocks are significantly undervalued and have substantial margins of safety, ranging from 9.9% to 26.28%, at these current bargain prices.
Implied Rate of Return
The implied rate of return of a stock is the expected rate of return that an investor would earn if they purchased the stock at its current price. It is different from the CAPM's expected rate of return that is used to calculate the stock's intrinsic value.
The equation for GGM is defined as P0 = D1/(Ke-g).
The equation can be rearranged as follows: Ke = (D1/P0) + g. Solving the equation provides the solution for Ke, the implied rate of return.
Calculating the Implied Rates of Return
The table below summarizes the implied rate of return for each stock as estimated using the rearranged GGM equation.
| Stock | Ticker | Expected Rate of Return based on CAPM | Implied Rate of Return based on Gordon Growth Model |
| Bank of China | 3988.HK | 9.55% | 11.88% |
| China Construction Bank | 939.HK | 10.58% | 12.22% |
| Industrial and Commercial Bank of China | 1398.HK | 9.24% | 11.47% |
| Agricultural Bank of China | 1288.HK | 9.04% | 11.09% |
| China Citic Bank | 998.HK | 10.48% | 12.96% |
| Chongqing Rural Commercial Bank | 3618.HK | 11.82% | 12.79% |
The summary table clearly shows that at the stock prices on November 1, 2023, the implied rates of return for these bank stocks are relatively attractive, ranging from 11.09% to 12.96%.
Conclusion
The valuation exercise as described above has shown that, at current price levels, the large China state-owned bank stocks trading on the Hong Kong stock exchange are significantly undervalued with substantial margins of safety and promise rewarding rates of return.
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.