Upload
gareth-cottam
View
166
Download
2
Embed Size (px)
Citation preview
東吳大學商學院企業管理學系碩士班 碩士論文
Soochow University Global Business Program School of Business
Thesis
從公開市場資訊衡量轉型經濟中的中國銀行業的內在
價值
The Measurement of Chinese Banks Intrinsic Value in its
Developing Securities Market
研究生 (Student)Gareth Cottam
指導教授(Advisor) Dr Muhan Nao (諾木汗)
This dissertation is submitted to Global Business Program
School of Business Soochow University
in partial Fulfilment of the Requirements
for the Degree of
Master
in
Business Administration
May 2011
i
Abstract This research is motivated by the importance of valuing firms or equity Without an
assessment of value price dictates an investorrsquos view of worth An estimated value
creates a reference point in which to compare with price This comparison can then be
used to base an investment decision to buy sell or hold The aim of this paper is to
examine valuation techniques with a focus on a practical issue of creating a valuation
range rather than a single lsquoprecisersquo number This study is the first to examine the
practical application of the Montgomery Method of valuing a company
KEY WORDS Value Investing Benjamin Graham Valuation Montgomery Method
ii
Acknowledgements I would like to express my heartfelt gratitude to the supervisor of my thesis Dr Muhan
Nao for his invaluable guidance and support His time and relentless effort spent in
reviewing my work are very much appreciated
My friend Colin Fukai was perhaps the most careful reader of multiple drafts of this
manuscript He is a true craftsman of the art of writing and his comments are literally
incorporated on every page of this paper I thank him for his tremendous assistance I am
also truly grateful for the support I received from my family and friends and of course to
my fellow MBA classmates whom I got to know over these last few semesters
As with any work such as this full responsibility for errors must be borne by the author I
hope those that remain are minor and few in number
iii
Table of Contents Abstract i
Acknowledgements ii
List of Tables vi
List of Figures vii
I Introduction 1
11 Background and Motivation 1
12 Purpose of the Research 3
13 Research Scope and Object 4
14 Significance of the Research 4
15 Research Process 5
II Literature Review 7
21 Chinarsquos Financial System 7
211 Chinese Banking Industry 7
212 Monopoly to Competition 7
213 Non-State-Owned Commercial Banks 9
214 Key Performance Indicators (KPIs) for Banks 9
215 Profit versus Profitability 10
216 Speculative Securities Market 12
22 Valuation scope What is value 14
221 Market Value 15
222 Fair Value 15
223 Book Value 15
224 Investment Value 15
225 Intrinsic Value 16
23 Valuation objective Why value companies 17
231 Valuation is not an exact science 18
232 Bargains and Value 19
24 Valuation methods How can companies be valued 20
241 Income Approach 21
iv
242 Market Approach 23
243 Asset Approach 23
25 The Worldrsquos Most Successful Investor 24
251 Fundamental Analysis 25
252 Valueable 25
26 Hypothesis 26
III Research Methodology 28
31 Introduction 28
32 Sampling and Data Collection 29
33 Valuation Models 30
331 Estimating Target Bankrsquos Value Using the Asset Approach 30
332 Estimating Target Bankrsquos Value Using the Market approach 30
333 Estimating Target Bankrsquos Value Using the Montgomery Method 30
34 Analysis 31
341 Hypothesis Testing 31
IV Results of the Comparison 33
41 Introduction 33
42 Descriptive Statistics Asset Approach 33
421 Non-State-Owned Banks 33
422 State-Owned Banks 36
43 Descriptive Statistics Market Approach 38
431 Non-State-Owned 38
432 State-Owned 42
44 Descriptive Statistics Montgomery Method 46
441 Non-State-Owned 47
442 State-Owned 48
45 Market Price Comparison with Value Range 48
451 Non-State-Owned 49
452 State-Owned 51
46 Macro Economic Factors 53
47 Results of Hypothesis Testing 54
48 Summary of Findings 56
v
V Research Findings and Conclusions 58
51 Introduction 58
52 Considerable Differences Among Various Evaluations 58
53 Research Implications 59
54 Limitations of the Research 59
55 Recommendations for Future Research 60
56 Conclusions 61
References and Bibliography 63
Appendix 70
vi
List of Tables Table 421-1 Bank of Communications 34
Table 421-2 CITIC Bank 34
Table 421-3 China Merchants Bank 35
Table 421-4 Shanghai Pudong Development Bank 35
Table 422-1 Agricultural Bank of China 36
Table 422-2 Bank of China 36
Table 422-3 China Construction Bank 37
Table 422-4 Industrial and Commercial Bank of China 37
Table 431-1 Summary of SPDB New Shares Issue Prices 41
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value 47
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value 48
Table 451-1 Bank of Communications 49
Table 451-2 CITIC Bank 49
Table 451-3 China Merchants Bank 50
Table 451-4 Shanghai Pudong Development Bank 50
Table 452-1 Agricultural Bank of China 51
Table 452-2 Bank of China 51
Table 452-3 China Construction Bank 52
Table 452-4 Industrial and Commercial Bank of China 52
vii
List of Figures Figure 46-1 Comparative discrepancy between market price and intrinsic value of non-
state-owned banks 55
Figure 46-2 Comparative discrepancy between market price and intrinsic value of state-
owned banks 56
1
I Introduction
11 Background and Motivation Greed is said to be a cardinal sin and yet it seems to be a recurring theme through the
ages Humanityrsquos tendency to succumb to ldquothe love of moneyrdquo1 can be seen from the
tulip mania in the mid-16th century the Wall Street Crash of 1929 continuing through
the 1987 ldquoBlack Mondayrdquo the Asian Financial Crisis Enron and the most recent sub-
prime collapse and subsequent Global Financial Crisis (GFC) (Sargent 2008) The world
has been rocked by one financial scandal after another
In 2001 the Enron accounting scandal and the subsequent failure of several other firms
such as WorldCom lead to the disgrace of the accounting firm Arthur Anderson (Healy
amp Palepu 2003) The sub-prime crisis and ensuing GFC can be linked to reckless
lending practices that led to the collapse of financial institutions such as Bear Stearns
Merrill Lynch and Lehman Brothers (Wei amp Corkery 2008) It seems that the financial
world does not learn from its mistakes
In light of such recent crisis the stability of the world financial system is called into
question Chinarsquos economy appears to have ridden out the storm well and ldquois an engine
of growthrdquo for the rest of the world (Ezrati 2010) The PRC has been credited with
leading the world out of the recent global recession and in 2010 surpassed Japan as the
worldrsquos second-largest economy (Hamlin amp Yanping 2010) So what is underlying the
Chinese economy
1 New Testament The love of money is the root of all evil (1 Timothy 610 KJV)
2
While Chinarsquos future influence on the global economy will undoubtedly increase this
should be tempered with an understanding that China is still a developing nation
Chinarsquos current financial system is dominated by a large banking sector that has been
accused of being inefficient and poorly regulated (Allen Qian Zhang amp Zhao 2010) If
China falters how will the world economy be affected What if the Chinese financial
system were to suffer a crisis similar to the sub-prime collapse Is this likely
As Chris Browne (2007) writes China is still a communist country The government
owns or controls many of the listed and traded companies on the Shanghai Shenzhen and
Hong Kong stock exchanges Investors are a silent partner with no recourse should the
government decide to change policies
ldquoBy market capitalisation it[China] has three of the four largest banks the two largest
insurance companies the second-largest stock market and a lengthening list of
investment fundsrdquo (Economist 2010) Chinese companies are coming to dominate the
financial markets of the world In fact the Industrial and Commercial Bank of China
(ICBC) is ranked the worldrsquos largest bank by assets and valuation while still majority
state-owned (Hamlin amp Yanping 2010) Is this a cause for concern
What does market capitalization mean According to Berk and DeMarzo (2007) market
capitalization is ldquothe total dollar market value of all of a companys outstanding
shares Market capitalization is calculated by multiplying a companys shares outstanding
by the current market price of one sharerdquo The investment community uses this figure in
determining a companys size as opposed to sales or total asset figures Given the
3
speculative nature of Chinarsquos developing securities markets (Wang amp Xu 2004) (Liu amp
Shrestha 2008) does this market capitalization figure represent the true value of the bank
Perhaps Hollywood producer Oliver Stone had good cause to revive his character
Gordon Gekko of the 1987 film Wall Street to play the antihero of the 2010 sequel
Gekko reminds us all the lessons to be learned from the mantra of Wall Street ldquoGreed is
goodrdquo It seems the cardinal rule of capitalism is that an item is worth what people will
pay but is the willingness of buyers to pay high prices a reliable indicator of value
12 Purpose of the Research The purpose of this paper is to apply appropriate valuation methodologies in an attempt
to measure the intrinsic value of Chinarsquos banks independently of their market price The
aim is to examine valuation techniques with a focus on a practical issue of creating a
valuation range rather than a single lsquoprecisersquo number
By examining the value range of the banks in comparison to their market prices we can
determine if a margin of safety exists and estimate the risk that must be assumed if
investing in Chinarsquos banks This research is of importance to anyone considering
investing in China from Institutional Investors to executives considering Mergers and
Acquisitions The research would play a key role in corporate finance as valuations can
be used to assist in value enhancing financial decisions and corporate strategies
The study is based on banks listed on the Chinese stock exchanges The data were
collected from annual reports extracted from websites and financial databases The
scope of the research is where possible for the previous five years of company financial
4
data including the year 2010 The data on each banks market price for comparison were
sourced from the Shanghai Exchange database
13 Research Scope and Object In this study the scope of the research was confined to the top four ranked state-owned
and non-state owned commercial banks These banks are highly visible in the market and
due to Chinarsquos acceptance into the World Trade Organization (WTO) in 2001 it is
assumed that their financial data is the easiest to source and potentially the most
transparent
Various valuation techniques were applied to establish a range of values for the selected
banks to use in comparison with their listed market prices The importance of this effort
is to establish if Chinese banks are undervalued overvalued or valued accordingly
These valuation figures will be used to test the research hypotheses
14 Significance of the Research This research adds to the existing body of knowledge regarding the valuation of banks
and in particular the value of the Chinese banks in the developing Chinese securities
markets
The Montgomery valuation method studied here also has potential uses for valuing
private firms There is a need to establish a more accurate method to value private firms
for initial public offerings mergers and acquisitions and so forth With the results of this
research and previous works such as Pratt et al (200) Thavikulwat (2004) and King
(2010) it is hoped that the valuation methods for private firms are improved
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
i
Abstract This research is motivated by the importance of valuing firms or equity Without an
assessment of value price dictates an investorrsquos view of worth An estimated value
creates a reference point in which to compare with price This comparison can then be
used to base an investment decision to buy sell or hold The aim of this paper is to
examine valuation techniques with a focus on a practical issue of creating a valuation
range rather than a single lsquoprecisersquo number This study is the first to examine the
practical application of the Montgomery Method of valuing a company
KEY WORDS Value Investing Benjamin Graham Valuation Montgomery Method
ii
Acknowledgements I would like to express my heartfelt gratitude to the supervisor of my thesis Dr Muhan
Nao for his invaluable guidance and support His time and relentless effort spent in
reviewing my work are very much appreciated
My friend Colin Fukai was perhaps the most careful reader of multiple drafts of this
manuscript He is a true craftsman of the art of writing and his comments are literally
incorporated on every page of this paper I thank him for his tremendous assistance I am
also truly grateful for the support I received from my family and friends and of course to
my fellow MBA classmates whom I got to know over these last few semesters
As with any work such as this full responsibility for errors must be borne by the author I
hope those that remain are minor and few in number
iii
Table of Contents Abstract i
Acknowledgements ii
List of Tables vi
List of Figures vii
I Introduction 1
11 Background and Motivation 1
12 Purpose of the Research 3
13 Research Scope and Object 4
14 Significance of the Research 4
15 Research Process 5
II Literature Review 7
21 Chinarsquos Financial System 7
211 Chinese Banking Industry 7
212 Monopoly to Competition 7
213 Non-State-Owned Commercial Banks 9
214 Key Performance Indicators (KPIs) for Banks 9
215 Profit versus Profitability 10
216 Speculative Securities Market 12
22 Valuation scope What is value 14
221 Market Value 15
222 Fair Value 15
223 Book Value 15
224 Investment Value 15
225 Intrinsic Value 16
23 Valuation objective Why value companies 17
231 Valuation is not an exact science 18
232 Bargains and Value 19
24 Valuation methods How can companies be valued 20
241 Income Approach 21
iv
242 Market Approach 23
243 Asset Approach 23
25 The Worldrsquos Most Successful Investor 24
251 Fundamental Analysis 25
252 Valueable 25
26 Hypothesis 26
III Research Methodology 28
31 Introduction 28
32 Sampling and Data Collection 29
33 Valuation Models 30
331 Estimating Target Bankrsquos Value Using the Asset Approach 30
332 Estimating Target Bankrsquos Value Using the Market approach 30
333 Estimating Target Bankrsquos Value Using the Montgomery Method 30
34 Analysis 31
341 Hypothesis Testing 31
IV Results of the Comparison 33
41 Introduction 33
42 Descriptive Statistics Asset Approach 33
421 Non-State-Owned Banks 33
422 State-Owned Banks 36
43 Descriptive Statistics Market Approach 38
431 Non-State-Owned 38
432 State-Owned 42
44 Descriptive Statistics Montgomery Method 46
441 Non-State-Owned 47
442 State-Owned 48
45 Market Price Comparison with Value Range 48
451 Non-State-Owned 49
452 State-Owned 51
46 Macro Economic Factors 53
47 Results of Hypothesis Testing 54
48 Summary of Findings 56
v
V Research Findings and Conclusions 58
51 Introduction 58
52 Considerable Differences Among Various Evaluations 58
53 Research Implications 59
54 Limitations of the Research 59
55 Recommendations for Future Research 60
56 Conclusions 61
References and Bibliography 63
Appendix 70
vi
List of Tables Table 421-1 Bank of Communications 34
Table 421-2 CITIC Bank 34
Table 421-3 China Merchants Bank 35
Table 421-4 Shanghai Pudong Development Bank 35
Table 422-1 Agricultural Bank of China 36
Table 422-2 Bank of China 36
Table 422-3 China Construction Bank 37
Table 422-4 Industrial and Commercial Bank of China 37
Table 431-1 Summary of SPDB New Shares Issue Prices 41
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value 47
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value 48
Table 451-1 Bank of Communications 49
Table 451-2 CITIC Bank 49
Table 451-3 China Merchants Bank 50
Table 451-4 Shanghai Pudong Development Bank 50
Table 452-1 Agricultural Bank of China 51
Table 452-2 Bank of China 51
Table 452-3 China Construction Bank 52
Table 452-4 Industrial and Commercial Bank of China 52
vii
List of Figures Figure 46-1 Comparative discrepancy between market price and intrinsic value of non-
state-owned banks 55
Figure 46-2 Comparative discrepancy between market price and intrinsic value of state-
owned banks 56
1
I Introduction
11 Background and Motivation Greed is said to be a cardinal sin and yet it seems to be a recurring theme through the
ages Humanityrsquos tendency to succumb to ldquothe love of moneyrdquo1 can be seen from the
tulip mania in the mid-16th century the Wall Street Crash of 1929 continuing through
the 1987 ldquoBlack Mondayrdquo the Asian Financial Crisis Enron and the most recent sub-
prime collapse and subsequent Global Financial Crisis (GFC) (Sargent 2008) The world
has been rocked by one financial scandal after another
In 2001 the Enron accounting scandal and the subsequent failure of several other firms
such as WorldCom lead to the disgrace of the accounting firm Arthur Anderson (Healy
amp Palepu 2003) The sub-prime crisis and ensuing GFC can be linked to reckless
lending practices that led to the collapse of financial institutions such as Bear Stearns
Merrill Lynch and Lehman Brothers (Wei amp Corkery 2008) It seems that the financial
world does not learn from its mistakes
In light of such recent crisis the stability of the world financial system is called into
question Chinarsquos economy appears to have ridden out the storm well and ldquois an engine
of growthrdquo for the rest of the world (Ezrati 2010) The PRC has been credited with
leading the world out of the recent global recession and in 2010 surpassed Japan as the
worldrsquos second-largest economy (Hamlin amp Yanping 2010) So what is underlying the
Chinese economy
1 New Testament The love of money is the root of all evil (1 Timothy 610 KJV)
2
While Chinarsquos future influence on the global economy will undoubtedly increase this
should be tempered with an understanding that China is still a developing nation
Chinarsquos current financial system is dominated by a large banking sector that has been
accused of being inefficient and poorly regulated (Allen Qian Zhang amp Zhao 2010) If
China falters how will the world economy be affected What if the Chinese financial
system were to suffer a crisis similar to the sub-prime collapse Is this likely
As Chris Browne (2007) writes China is still a communist country The government
owns or controls many of the listed and traded companies on the Shanghai Shenzhen and
Hong Kong stock exchanges Investors are a silent partner with no recourse should the
government decide to change policies
ldquoBy market capitalisation it[China] has three of the four largest banks the two largest
insurance companies the second-largest stock market and a lengthening list of
investment fundsrdquo (Economist 2010) Chinese companies are coming to dominate the
financial markets of the world In fact the Industrial and Commercial Bank of China
(ICBC) is ranked the worldrsquos largest bank by assets and valuation while still majority
state-owned (Hamlin amp Yanping 2010) Is this a cause for concern
What does market capitalization mean According to Berk and DeMarzo (2007) market
capitalization is ldquothe total dollar market value of all of a companys outstanding
shares Market capitalization is calculated by multiplying a companys shares outstanding
by the current market price of one sharerdquo The investment community uses this figure in
determining a companys size as opposed to sales or total asset figures Given the
3
speculative nature of Chinarsquos developing securities markets (Wang amp Xu 2004) (Liu amp
Shrestha 2008) does this market capitalization figure represent the true value of the bank
Perhaps Hollywood producer Oliver Stone had good cause to revive his character
Gordon Gekko of the 1987 film Wall Street to play the antihero of the 2010 sequel
Gekko reminds us all the lessons to be learned from the mantra of Wall Street ldquoGreed is
goodrdquo It seems the cardinal rule of capitalism is that an item is worth what people will
pay but is the willingness of buyers to pay high prices a reliable indicator of value
12 Purpose of the Research The purpose of this paper is to apply appropriate valuation methodologies in an attempt
to measure the intrinsic value of Chinarsquos banks independently of their market price The
aim is to examine valuation techniques with a focus on a practical issue of creating a
valuation range rather than a single lsquoprecisersquo number
By examining the value range of the banks in comparison to their market prices we can
determine if a margin of safety exists and estimate the risk that must be assumed if
investing in Chinarsquos banks This research is of importance to anyone considering
investing in China from Institutional Investors to executives considering Mergers and
Acquisitions The research would play a key role in corporate finance as valuations can
be used to assist in value enhancing financial decisions and corporate strategies
The study is based on banks listed on the Chinese stock exchanges The data were
collected from annual reports extracted from websites and financial databases The
scope of the research is where possible for the previous five years of company financial
4
data including the year 2010 The data on each banks market price for comparison were
sourced from the Shanghai Exchange database
13 Research Scope and Object In this study the scope of the research was confined to the top four ranked state-owned
and non-state owned commercial banks These banks are highly visible in the market and
due to Chinarsquos acceptance into the World Trade Organization (WTO) in 2001 it is
assumed that their financial data is the easiest to source and potentially the most
transparent
Various valuation techniques were applied to establish a range of values for the selected
banks to use in comparison with their listed market prices The importance of this effort
is to establish if Chinese banks are undervalued overvalued or valued accordingly
These valuation figures will be used to test the research hypotheses
14 Significance of the Research This research adds to the existing body of knowledge regarding the valuation of banks
and in particular the value of the Chinese banks in the developing Chinese securities
markets
The Montgomery valuation method studied here also has potential uses for valuing
private firms There is a need to establish a more accurate method to value private firms
for initial public offerings mergers and acquisitions and so forth With the results of this
research and previous works such as Pratt et al (200) Thavikulwat (2004) and King
(2010) it is hoped that the valuation methods for private firms are improved
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
ii
Acknowledgements I would like to express my heartfelt gratitude to the supervisor of my thesis Dr Muhan
Nao for his invaluable guidance and support His time and relentless effort spent in
reviewing my work are very much appreciated
My friend Colin Fukai was perhaps the most careful reader of multiple drafts of this
manuscript He is a true craftsman of the art of writing and his comments are literally
incorporated on every page of this paper I thank him for his tremendous assistance I am
also truly grateful for the support I received from my family and friends and of course to
my fellow MBA classmates whom I got to know over these last few semesters
As with any work such as this full responsibility for errors must be borne by the author I
hope those that remain are minor and few in number
iii
Table of Contents Abstract i
Acknowledgements ii
List of Tables vi
List of Figures vii
I Introduction 1
11 Background and Motivation 1
12 Purpose of the Research 3
13 Research Scope and Object 4
14 Significance of the Research 4
15 Research Process 5
II Literature Review 7
21 Chinarsquos Financial System 7
211 Chinese Banking Industry 7
212 Monopoly to Competition 7
213 Non-State-Owned Commercial Banks 9
214 Key Performance Indicators (KPIs) for Banks 9
215 Profit versus Profitability 10
216 Speculative Securities Market 12
22 Valuation scope What is value 14
221 Market Value 15
222 Fair Value 15
223 Book Value 15
224 Investment Value 15
225 Intrinsic Value 16
23 Valuation objective Why value companies 17
231 Valuation is not an exact science 18
232 Bargains and Value 19
24 Valuation methods How can companies be valued 20
241 Income Approach 21
iv
242 Market Approach 23
243 Asset Approach 23
25 The Worldrsquos Most Successful Investor 24
251 Fundamental Analysis 25
252 Valueable 25
26 Hypothesis 26
III Research Methodology 28
31 Introduction 28
32 Sampling and Data Collection 29
33 Valuation Models 30
331 Estimating Target Bankrsquos Value Using the Asset Approach 30
332 Estimating Target Bankrsquos Value Using the Market approach 30
333 Estimating Target Bankrsquos Value Using the Montgomery Method 30
34 Analysis 31
341 Hypothesis Testing 31
IV Results of the Comparison 33
41 Introduction 33
42 Descriptive Statistics Asset Approach 33
421 Non-State-Owned Banks 33
422 State-Owned Banks 36
43 Descriptive Statistics Market Approach 38
431 Non-State-Owned 38
432 State-Owned 42
44 Descriptive Statistics Montgomery Method 46
441 Non-State-Owned 47
442 State-Owned 48
45 Market Price Comparison with Value Range 48
451 Non-State-Owned 49
452 State-Owned 51
46 Macro Economic Factors 53
47 Results of Hypothesis Testing 54
48 Summary of Findings 56
v
V Research Findings and Conclusions 58
51 Introduction 58
52 Considerable Differences Among Various Evaluations 58
53 Research Implications 59
54 Limitations of the Research 59
55 Recommendations for Future Research 60
56 Conclusions 61
References and Bibliography 63
Appendix 70
vi
List of Tables Table 421-1 Bank of Communications 34
Table 421-2 CITIC Bank 34
Table 421-3 China Merchants Bank 35
Table 421-4 Shanghai Pudong Development Bank 35
Table 422-1 Agricultural Bank of China 36
Table 422-2 Bank of China 36
Table 422-3 China Construction Bank 37
Table 422-4 Industrial and Commercial Bank of China 37
Table 431-1 Summary of SPDB New Shares Issue Prices 41
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value 47
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value 48
Table 451-1 Bank of Communications 49
Table 451-2 CITIC Bank 49
Table 451-3 China Merchants Bank 50
Table 451-4 Shanghai Pudong Development Bank 50
Table 452-1 Agricultural Bank of China 51
Table 452-2 Bank of China 51
Table 452-3 China Construction Bank 52
Table 452-4 Industrial and Commercial Bank of China 52
vii
List of Figures Figure 46-1 Comparative discrepancy between market price and intrinsic value of non-
state-owned banks 55
Figure 46-2 Comparative discrepancy between market price and intrinsic value of state-
owned banks 56
1
I Introduction
11 Background and Motivation Greed is said to be a cardinal sin and yet it seems to be a recurring theme through the
ages Humanityrsquos tendency to succumb to ldquothe love of moneyrdquo1 can be seen from the
tulip mania in the mid-16th century the Wall Street Crash of 1929 continuing through
the 1987 ldquoBlack Mondayrdquo the Asian Financial Crisis Enron and the most recent sub-
prime collapse and subsequent Global Financial Crisis (GFC) (Sargent 2008) The world
has been rocked by one financial scandal after another
In 2001 the Enron accounting scandal and the subsequent failure of several other firms
such as WorldCom lead to the disgrace of the accounting firm Arthur Anderson (Healy
amp Palepu 2003) The sub-prime crisis and ensuing GFC can be linked to reckless
lending practices that led to the collapse of financial institutions such as Bear Stearns
Merrill Lynch and Lehman Brothers (Wei amp Corkery 2008) It seems that the financial
world does not learn from its mistakes
In light of such recent crisis the stability of the world financial system is called into
question Chinarsquos economy appears to have ridden out the storm well and ldquois an engine
of growthrdquo for the rest of the world (Ezrati 2010) The PRC has been credited with
leading the world out of the recent global recession and in 2010 surpassed Japan as the
worldrsquos second-largest economy (Hamlin amp Yanping 2010) So what is underlying the
Chinese economy
1 New Testament The love of money is the root of all evil (1 Timothy 610 KJV)
2
While Chinarsquos future influence on the global economy will undoubtedly increase this
should be tempered with an understanding that China is still a developing nation
Chinarsquos current financial system is dominated by a large banking sector that has been
accused of being inefficient and poorly regulated (Allen Qian Zhang amp Zhao 2010) If
China falters how will the world economy be affected What if the Chinese financial
system were to suffer a crisis similar to the sub-prime collapse Is this likely
As Chris Browne (2007) writes China is still a communist country The government
owns or controls many of the listed and traded companies on the Shanghai Shenzhen and
Hong Kong stock exchanges Investors are a silent partner with no recourse should the
government decide to change policies
ldquoBy market capitalisation it[China] has three of the four largest banks the two largest
insurance companies the second-largest stock market and a lengthening list of
investment fundsrdquo (Economist 2010) Chinese companies are coming to dominate the
financial markets of the world In fact the Industrial and Commercial Bank of China
(ICBC) is ranked the worldrsquos largest bank by assets and valuation while still majority
state-owned (Hamlin amp Yanping 2010) Is this a cause for concern
What does market capitalization mean According to Berk and DeMarzo (2007) market
capitalization is ldquothe total dollar market value of all of a companys outstanding
shares Market capitalization is calculated by multiplying a companys shares outstanding
by the current market price of one sharerdquo The investment community uses this figure in
determining a companys size as opposed to sales or total asset figures Given the
3
speculative nature of Chinarsquos developing securities markets (Wang amp Xu 2004) (Liu amp
Shrestha 2008) does this market capitalization figure represent the true value of the bank
Perhaps Hollywood producer Oliver Stone had good cause to revive his character
Gordon Gekko of the 1987 film Wall Street to play the antihero of the 2010 sequel
Gekko reminds us all the lessons to be learned from the mantra of Wall Street ldquoGreed is
goodrdquo It seems the cardinal rule of capitalism is that an item is worth what people will
pay but is the willingness of buyers to pay high prices a reliable indicator of value
12 Purpose of the Research The purpose of this paper is to apply appropriate valuation methodologies in an attempt
to measure the intrinsic value of Chinarsquos banks independently of their market price The
aim is to examine valuation techniques with a focus on a practical issue of creating a
valuation range rather than a single lsquoprecisersquo number
By examining the value range of the banks in comparison to their market prices we can
determine if a margin of safety exists and estimate the risk that must be assumed if
investing in Chinarsquos banks This research is of importance to anyone considering
investing in China from Institutional Investors to executives considering Mergers and
Acquisitions The research would play a key role in corporate finance as valuations can
be used to assist in value enhancing financial decisions and corporate strategies
The study is based on banks listed on the Chinese stock exchanges The data were
collected from annual reports extracted from websites and financial databases The
scope of the research is where possible for the previous five years of company financial
4
data including the year 2010 The data on each banks market price for comparison were
sourced from the Shanghai Exchange database
13 Research Scope and Object In this study the scope of the research was confined to the top four ranked state-owned
and non-state owned commercial banks These banks are highly visible in the market and
due to Chinarsquos acceptance into the World Trade Organization (WTO) in 2001 it is
assumed that their financial data is the easiest to source and potentially the most
transparent
Various valuation techniques were applied to establish a range of values for the selected
banks to use in comparison with their listed market prices The importance of this effort
is to establish if Chinese banks are undervalued overvalued or valued accordingly
These valuation figures will be used to test the research hypotheses
14 Significance of the Research This research adds to the existing body of knowledge regarding the valuation of banks
and in particular the value of the Chinese banks in the developing Chinese securities
markets
The Montgomery valuation method studied here also has potential uses for valuing
private firms There is a need to establish a more accurate method to value private firms
for initial public offerings mergers and acquisitions and so forth With the results of this
research and previous works such as Pratt et al (200) Thavikulwat (2004) and King
(2010) it is hoped that the valuation methods for private firms are improved
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
iii
Table of Contents Abstract i
Acknowledgements ii
List of Tables vi
List of Figures vii
I Introduction 1
11 Background and Motivation 1
12 Purpose of the Research 3
13 Research Scope and Object 4
14 Significance of the Research 4
15 Research Process 5
II Literature Review 7
21 Chinarsquos Financial System 7
211 Chinese Banking Industry 7
212 Monopoly to Competition 7
213 Non-State-Owned Commercial Banks 9
214 Key Performance Indicators (KPIs) for Banks 9
215 Profit versus Profitability 10
216 Speculative Securities Market 12
22 Valuation scope What is value 14
221 Market Value 15
222 Fair Value 15
223 Book Value 15
224 Investment Value 15
225 Intrinsic Value 16
23 Valuation objective Why value companies 17
231 Valuation is not an exact science 18
232 Bargains and Value 19
24 Valuation methods How can companies be valued 20
241 Income Approach 21
iv
242 Market Approach 23
243 Asset Approach 23
25 The Worldrsquos Most Successful Investor 24
251 Fundamental Analysis 25
252 Valueable 25
26 Hypothesis 26
III Research Methodology 28
31 Introduction 28
32 Sampling and Data Collection 29
33 Valuation Models 30
331 Estimating Target Bankrsquos Value Using the Asset Approach 30
332 Estimating Target Bankrsquos Value Using the Market approach 30
333 Estimating Target Bankrsquos Value Using the Montgomery Method 30
34 Analysis 31
341 Hypothesis Testing 31
IV Results of the Comparison 33
41 Introduction 33
42 Descriptive Statistics Asset Approach 33
421 Non-State-Owned Banks 33
422 State-Owned Banks 36
43 Descriptive Statistics Market Approach 38
431 Non-State-Owned 38
432 State-Owned 42
44 Descriptive Statistics Montgomery Method 46
441 Non-State-Owned 47
442 State-Owned 48
45 Market Price Comparison with Value Range 48
451 Non-State-Owned 49
452 State-Owned 51
46 Macro Economic Factors 53
47 Results of Hypothesis Testing 54
48 Summary of Findings 56
v
V Research Findings and Conclusions 58
51 Introduction 58
52 Considerable Differences Among Various Evaluations 58
53 Research Implications 59
54 Limitations of the Research 59
55 Recommendations for Future Research 60
56 Conclusions 61
References and Bibliography 63
Appendix 70
vi
List of Tables Table 421-1 Bank of Communications 34
Table 421-2 CITIC Bank 34
Table 421-3 China Merchants Bank 35
Table 421-4 Shanghai Pudong Development Bank 35
Table 422-1 Agricultural Bank of China 36
Table 422-2 Bank of China 36
Table 422-3 China Construction Bank 37
Table 422-4 Industrial and Commercial Bank of China 37
Table 431-1 Summary of SPDB New Shares Issue Prices 41
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value 47
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value 48
Table 451-1 Bank of Communications 49
Table 451-2 CITIC Bank 49
Table 451-3 China Merchants Bank 50
Table 451-4 Shanghai Pudong Development Bank 50
Table 452-1 Agricultural Bank of China 51
Table 452-2 Bank of China 51
Table 452-3 China Construction Bank 52
Table 452-4 Industrial and Commercial Bank of China 52
vii
List of Figures Figure 46-1 Comparative discrepancy between market price and intrinsic value of non-
state-owned banks 55
Figure 46-2 Comparative discrepancy between market price and intrinsic value of state-
owned banks 56
1
I Introduction
11 Background and Motivation Greed is said to be a cardinal sin and yet it seems to be a recurring theme through the
ages Humanityrsquos tendency to succumb to ldquothe love of moneyrdquo1 can be seen from the
tulip mania in the mid-16th century the Wall Street Crash of 1929 continuing through
the 1987 ldquoBlack Mondayrdquo the Asian Financial Crisis Enron and the most recent sub-
prime collapse and subsequent Global Financial Crisis (GFC) (Sargent 2008) The world
has been rocked by one financial scandal after another
In 2001 the Enron accounting scandal and the subsequent failure of several other firms
such as WorldCom lead to the disgrace of the accounting firm Arthur Anderson (Healy
amp Palepu 2003) The sub-prime crisis and ensuing GFC can be linked to reckless
lending practices that led to the collapse of financial institutions such as Bear Stearns
Merrill Lynch and Lehman Brothers (Wei amp Corkery 2008) It seems that the financial
world does not learn from its mistakes
In light of such recent crisis the stability of the world financial system is called into
question Chinarsquos economy appears to have ridden out the storm well and ldquois an engine
of growthrdquo for the rest of the world (Ezrati 2010) The PRC has been credited with
leading the world out of the recent global recession and in 2010 surpassed Japan as the
worldrsquos second-largest economy (Hamlin amp Yanping 2010) So what is underlying the
Chinese economy
1 New Testament The love of money is the root of all evil (1 Timothy 610 KJV)
2
While Chinarsquos future influence on the global economy will undoubtedly increase this
should be tempered with an understanding that China is still a developing nation
Chinarsquos current financial system is dominated by a large banking sector that has been
accused of being inefficient and poorly regulated (Allen Qian Zhang amp Zhao 2010) If
China falters how will the world economy be affected What if the Chinese financial
system were to suffer a crisis similar to the sub-prime collapse Is this likely
As Chris Browne (2007) writes China is still a communist country The government
owns or controls many of the listed and traded companies on the Shanghai Shenzhen and
Hong Kong stock exchanges Investors are a silent partner with no recourse should the
government decide to change policies
ldquoBy market capitalisation it[China] has three of the four largest banks the two largest
insurance companies the second-largest stock market and a lengthening list of
investment fundsrdquo (Economist 2010) Chinese companies are coming to dominate the
financial markets of the world In fact the Industrial and Commercial Bank of China
(ICBC) is ranked the worldrsquos largest bank by assets and valuation while still majority
state-owned (Hamlin amp Yanping 2010) Is this a cause for concern
What does market capitalization mean According to Berk and DeMarzo (2007) market
capitalization is ldquothe total dollar market value of all of a companys outstanding
shares Market capitalization is calculated by multiplying a companys shares outstanding
by the current market price of one sharerdquo The investment community uses this figure in
determining a companys size as opposed to sales or total asset figures Given the
3
speculative nature of Chinarsquos developing securities markets (Wang amp Xu 2004) (Liu amp
Shrestha 2008) does this market capitalization figure represent the true value of the bank
Perhaps Hollywood producer Oliver Stone had good cause to revive his character
Gordon Gekko of the 1987 film Wall Street to play the antihero of the 2010 sequel
Gekko reminds us all the lessons to be learned from the mantra of Wall Street ldquoGreed is
goodrdquo It seems the cardinal rule of capitalism is that an item is worth what people will
pay but is the willingness of buyers to pay high prices a reliable indicator of value
12 Purpose of the Research The purpose of this paper is to apply appropriate valuation methodologies in an attempt
to measure the intrinsic value of Chinarsquos banks independently of their market price The
aim is to examine valuation techniques with a focus on a practical issue of creating a
valuation range rather than a single lsquoprecisersquo number
By examining the value range of the banks in comparison to their market prices we can
determine if a margin of safety exists and estimate the risk that must be assumed if
investing in Chinarsquos banks This research is of importance to anyone considering
investing in China from Institutional Investors to executives considering Mergers and
Acquisitions The research would play a key role in corporate finance as valuations can
be used to assist in value enhancing financial decisions and corporate strategies
The study is based on banks listed on the Chinese stock exchanges The data were
collected from annual reports extracted from websites and financial databases The
scope of the research is where possible for the previous five years of company financial
4
data including the year 2010 The data on each banks market price for comparison were
sourced from the Shanghai Exchange database
13 Research Scope and Object In this study the scope of the research was confined to the top four ranked state-owned
and non-state owned commercial banks These banks are highly visible in the market and
due to Chinarsquos acceptance into the World Trade Organization (WTO) in 2001 it is
assumed that their financial data is the easiest to source and potentially the most
transparent
Various valuation techniques were applied to establish a range of values for the selected
banks to use in comparison with their listed market prices The importance of this effort
is to establish if Chinese banks are undervalued overvalued or valued accordingly
These valuation figures will be used to test the research hypotheses
14 Significance of the Research This research adds to the existing body of knowledge regarding the valuation of banks
and in particular the value of the Chinese banks in the developing Chinese securities
markets
The Montgomery valuation method studied here also has potential uses for valuing
private firms There is a need to establish a more accurate method to value private firms
for initial public offerings mergers and acquisitions and so forth With the results of this
research and previous works such as Pratt et al (200) Thavikulwat (2004) and King
(2010) it is hoped that the valuation methods for private firms are improved
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
iv
242 Market Approach 23
243 Asset Approach 23
25 The Worldrsquos Most Successful Investor 24
251 Fundamental Analysis 25
252 Valueable 25
26 Hypothesis 26
III Research Methodology 28
31 Introduction 28
32 Sampling and Data Collection 29
33 Valuation Models 30
331 Estimating Target Bankrsquos Value Using the Asset Approach 30
332 Estimating Target Bankrsquos Value Using the Market approach 30
333 Estimating Target Bankrsquos Value Using the Montgomery Method 30
34 Analysis 31
341 Hypothesis Testing 31
IV Results of the Comparison 33
41 Introduction 33
42 Descriptive Statistics Asset Approach 33
421 Non-State-Owned Banks 33
422 State-Owned Banks 36
43 Descriptive Statistics Market Approach 38
431 Non-State-Owned 38
432 State-Owned 42
44 Descriptive Statistics Montgomery Method 46
441 Non-State-Owned 47
442 State-Owned 48
45 Market Price Comparison with Value Range 48
451 Non-State-Owned 49
452 State-Owned 51
46 Macro Economic Factors 53
47 Results of Hypothesis Testing 54
48 Summary of Findings 56
v
V Research Findings and Conclusions 58
51 Introduction 58
52 Considerable Differences Among Various Evaluations 58
53 Research Implications 59
54 Limitations of the Research 59
55 Recommendations for Future Research 60
56 Conclusions 61
References and Bibliography 63
Appendix 70
vi
List of Tables Table 421-1 Bank of Communications 34
Table 421-2 CITIC Bank 34
Table 421-3 China Merchants Bank 35
Table 421-4 Shanghai Pudong Development Bank 35
Table 422-1 Agricultural Bank of China 36
Table 422-2 Bank of China 36
Table 422-3 China Construction Bank 37
Table 422-4 Industrial and Commercial Bank of China 37
Table 431-1 Summary of SPDB New Shares Issue Prices 41
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value 47
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value 48
Table 451-1 Bank of Communications 49
Table 451-2 CITIC Bank 49
Table 451-3 China Merchants Bank 50
Table 451-4 Shanghai Pudong Development Bank 50
Table 452-1 Agricultural Bank of China 51
Table 452-2 Bank of China 51
Table 452-3 China Construction Bank 52
Table 452-4 Industrial and Commercial Bank of China 52
vii
List of Figures Figure 46-1 Comparative discrepancy between market price and intrinsic value of non-
state-owned banks 55
Figure 46-2 Comparative discrepancy between market price and intrinsic value of state-
owned banks 56
1
I Introduction
11 Background and Motivation Greed is said to be a cardinal sin and yet it seems to be a recurring theme through the
ages Humanityrsquos tendency to succumb to ldquothe love of moneyrdquo1 can be seen from the
tulip mania in the mid-16th century the Wall Street Crash of 1929 continuing through
the 1987 ldquoBlack Mondayrdquo the Asian Financial Crisis Enron and the most recent sub-
prime collapse and subsequent Global Financial Crisis (GFC) (Sargent 2008) The world
has been rocked by one financial scandal after another
In 2001 the Enron accounting scandal and the subsequent failure of several other firms
such as WorldCom lead to the disgrace of the accounting firm Arthur Anderson (Healy
amp Palepu 2003) The sub-prime crisis and ensuing GFC can be linked to reckless
lending practices that led to the collapse of financial institutions such as Bear Stearns
Merrill Lynch and Lehman Brothers (Wei amp Corkery 2008) It seems that the financial
world does not learn from its mistakes
In light of such recent crisis the stability of the world financial system is called into
question Chinarsquos economy appears to have ridden out the storm well and ldquois an engine
of growthrdquo for the rest of the world (Ezrati 2010) The PRC has been credited with
leading the world out of the recent global recession and in 2010 surpassed Japan as the
worldrsquos second-largest economy (Hamlin amp Yanping 2010) So what is underlying the
Chinese economy
1 New Testament The love of money is the root of all evil (1 Timothy 610 KJV)
2
While Chinarsquos future influence on the global economy will undoubtedly increase this
should be tempered with an understanding that China is still a developing nation
Chinarsquos current financial system is dominated by a large banking sector that has been
accused of being inefficient and poorly regulated (Allen Qian Zhang amp Zhao 2010) If
China falters how will the world economy be affected What if the Chinese financial
system were to suffer a crisis similar to the sub-prime collapse Is this likely
As Chris Browne (2007) writes China is still a communist country The government
owns or controls many of the listed and traded companies on the Shanghai Shenzhen and
Hong Kong stock exchanges Investors are a silent partner with no recourse should the
government decide to change policies
ldquoBy market capitalisation it[China] has three of the four largest banks the two largest
insurance companies the second-largest stock market and a lengthening list of
investment fundsrdquo (Economist 2010) Chinese companies are coming to dominate the
financial markets of the world In fact the Industrial and Commercial Bank of China
(ICBC) is ranked the worldrsquos largest bank by assets and valuation while still majority
state-owned (Hamlin amp Yanping 2010) Is this a cause for concern
What does market capitalization mean According to Berk and DeMarzo (2007) market
capitalization is ldquothe total dollar market value of all of a companys outstanding
shares Market capitalization is calculated by multiplying a companys shares outstanding
by the current market price of one sharerdquo The investment community uses this figure in
determining a companys size as opposed to sales or total asset figures Given the
3
speculative nature of Chinarsquos developing securities markets (Wang amp Xu 2004) (Liu amp
Shrestha 2008) does this market capitalization figure represent the true value of the bank
Perhaps Hollywood producer Oliver Stone had good cause to revive his character
Gordon Gekko of the 1987 film Wall Street to play the antihero of the 2010 sequel
Gekko reminds us all the lessons to be learned from the mantra of Wall Street ldquoGreed is
goodrdquo It seems the cardinal rule of capitalism is that an item is worth what people will
pay but is the willingness of buyers to pay high prices a reliable indicator of value
12 Purpose of the Research The purpose of this paper is to apply appropriate valuation methodologies in an attempt
to measure the intrinsic value of Chinarsquos banks independently of their market price The
aim is to examine valuation techniques with a focus on a practical issue of creating a
valuation range rather than a single lsquoprecisersquo number
By examining the value range of the banks in comparison to their market prices we can
determine if a margin of safety exists and estimate the risk that must be assumed if
investing in Chinarsquos banks This research is of importance to anyone considering
investing in China from Institutional Investors to executives considering Mergers and
Acquisitions The research would play a key role in corporate finance as valuations can
be used to assist in value enhancing financial decisions and corporate strategies
The study is based on banks listed on the Chinese stock exchanges The data were
collected from annual reports extracted from websites and financial databases The
scope of the research is where possible for the previous five years of company financial
4
data including the year 2010 The data on each banks market price for comparison were
sourced from the Shanghai Exchange database
13 Research Scope and Object In this study the scope of the research was confined to the top four ranked state-owned
and non-state owned commercial banks These banks are highly visible in the market and
due to Chinarsquos acceptance into the World Trade Organization (WTO) in 2001 it is
assumed that their financial data is the easiest to source and potentially the most
transparent
Various valuation techniques were applied to establish a range of values for the selected
banks to use in comparison with their listed market prices The importance of this effort
is to establish if Chinese banks are undervalued overvalued or valued accordingly
These valuation figures will be used to test the research hypotheses
14 Significance of the Research This research adds to the existing body of knowledge regarding the valuation of banks
and in particular the value of the Chinese banks in the developing Chinese securities
markets
The Montgomery valuation method studied here also has potential uses for valuing
private firms There is a need to establish a more accurate method to value private firms
for initial public offerings mergers and acquisitions and so forth With the results of this
research and previous works such as Pratt et al (200) Thavikulwat (2004) and King
(2010) it is hoped that the valuation methods for private firms are improved
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
v
V Research Findings and Conclusions 58
51 Introduction 58
52 Considerable Differences Among Various Evaluations 58
53 Research Implications 59
54 Limitations of the Research 59
55 Recommendations for Future Research 60
56 Conclusions 61
References and Bibliography 63
Appendix 70
vi
List of Tables Table 421-1 Bank of Communications 34
Table 421-2 CITIC Bank 34
Table 421-3 China Merchants Bank 35
Table 421-4 Shanghai Pudong Development Bank 35
Table 422-1 Agricultural Bank of China 36
Table 422-2 Bank of China 36
Table 422-3 China Construction Bank 37
Table 422-4 Industrial and Commercial Bank of China 37
Table 431-1 Summary of SPDB New Shares Issue Prices 41
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value 47
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value 48
Table 451-1 Bank of Communications 49
Table 451-2 CITIC Bank 49
Table 451-3 China Merchants Bank 50
Table 451-4 Shanghai Pudong Development Bank 50
Table 452-1 Agricultural Bank of China 51
Table 452-2 Bank of China 51
Table 452-3 China Construction Bank 52
Table 452-4 Industrial and Commercial Bank of China 52
vii
List of Figures Figure 46-1 Comparative discrepancy between market price and intrinsic value of non-
state-owned banks 55
Figure 46-2 Comparative discrepancy between market price and intrinsic value of state-
owned banks 56
1
I Introduction
11 Background and Motivation Greed is said to be a cardinal sin and yet it seems to be a recurring theme through the
ages Humanityrsquos tendency to succumb to ldquothe love of moneyrdquo1 can be seen from the
tulip mania in the mid-16th century the Wall Street Crash of 1929 continuing through
the 1987 ldquoBlack Mondayrdquo the Asian Financial Crisis Enron and the most recent sub-
prime collapse and subsequent Global Financial Crisis (GFC) (Sargent 2008) The world
has been rocked by one financial scandal after another
In 2001 the Enron accounting scandal and the subsequent failure of several other firms
such as WorldCom lead to the disgrace of the accounting firm Arthur Anderson (Healy
amp Palepu 2003) The sub-prime crisis and ensuing GFC can be linked to reckless
lending practices that led to the collapse of financial institutions such as Bear Stearns
Merrill Lynch and Lehman Brothers (Wei amp Corkery 2008) It seems that the financial
world does not learn from its mistakes
In light of such recent crisis the stability of the world financial system is called into
question Chinarsquos economy appears to have ridden out the storm well and ldquois an engine
of growthrdquo for the rest of the world (Ezrati 2010) The PRC has been credited with
leading the world out of the recent global recession and in 2010 surpassed Japan as the
worldrsquos second-largest economy (Hamlin amp Yanping 2010) So what is underlying the
Chinese economy
1 New Testament The love of money is the root of all evil (1 Timothy 610 KJV)
2
While Chinarsquos future influence on the global economy will undoubtedly increase this
should be tempered with an understanding that China is still a developing nation
Chinarsquos current financial system is dominated by a large banking sector that has been
accused of being inefficient and poorly regulated (Allen Qian Zhang amp Zhao 2010) If
China falters how will the world economy be affected What if the Chinese financial
system were to suffer a crisis similar to the sub-prime collapse Is this likely
As Chris Browne (2007) writes China is still a communist country The government
owns or controls many of the listed and traded companies on the Shanghai Shenzhen and
Hong Kong stock exchanges Investors are a silent partner with no recourse should the
government decide to change policies
ldquoBy market capitalisation it[China] has three of the four largest banks the two largest
insurance companies the second-largest stock market and a lengthening list of
investment fundsrdquo (Economist 2010) Chinese companies are coming to dominate the
financial markets of the world In fact the Industrial and Commercial Bank of China
(ICBC) is ranked the worldrsquos largest bank by assets and valuation while still majority
state-owned (Hamlin amp Yanping 2010) Is this a cause for concern
What does market capitalization mean According to Berk and DeMarzo (2007) market
capitalization is ldquothe total dollar market value of all of a companys outstanding
shares Market capitalization is calculated by multiplying a companys shares outstanding
by the current market price of one sharerdquo The investment community uses this figure in
determining a companys size as opposed to sales or total asset figures Given the
3
speculative nature of Chinarsquos developing securities markets (Wang amp Xu 2004) (Liu amp
Shrestha 2008) does this market capitalization figure represent the true value of the bank
Perhaps Hollywood producer Oliver Stone had good cause to revive his character
Gordon Gekko of the 1987 film Wall Street to play the antihero of the 2010 sequel
Gekko reminds us all the lessons to be learned from the mantra of Wall Street ldquoGreed is
goodrdquo It seems the cardinal rule of capitalism is that an item is worth what people will
pay but is the willingness of buyers to pay high prices a reliable indicator of value
12 Purpose of the Research The purpose of this paper is to apply appropriate valuation methodologies in an attempt
to measure the intrinsic value of Chinarsquos banks independently of their market price The
aim is to examine valuation techniques with a focus on a practical issue of creating a
valuation range rather than a single lsquoprecisersquo number
By examining the value range of the banks in comparison to their market prices we can
determine if a margin of safety exists and estimate the risk that must be assumed if
investing in Chinarsquos banks This research is of importance to anyone considering
investing in China from Institutional Investors to executives considering Mergers and
Acquisitions The research would play a key role in corporate finance as valuations can
be used to assist in value enhancing financial decisions and corporate strategies
The study is based on banks listed on the Chinese stock exchanges The data were
collected from annual reports extracted from websites and financial databases The
scope of the research is where possible for the previous five years of company financial
4
data including the year 2010 The data on each banks market price for comparison were
sourced from the Shanghai Exchange database
13 Research Scope and Object In this study the scope of the research was confined to the top four ranked state-owned
and non-state owned commercial banks These banks are highly visible in the market and
due to Chinarsquos acceptance into the World Trade Organization (WTO) in 2001 it is
assumed that their financial data is the easiest to source and potentially the most
transparent
Various valuation techniques were applied to establish a range of values for the selected
banks to use in comparison with their listed market prices The importance of this effort
is to establish if Chinese banks are undervalued overvalued or valued accordingly
These valuation figures will be used to test the research hypotheses
14 Significance of the Research This research adds to the existing body of knowledge regarding the valuation of banks
and in particular the value of the Chinese banks in the developing Chinese securities
markets
The Montgomery valuation method studied here also has potential uses for valuing
private firms There is a need to establish a more accurate method to value private firms
for initial public offerings mergers and acquisitions and so forth With the results of this
research and previous works such as Pratt et al (200) Thavikulwat (2004) and King
(2010) it is hoped that the valuation methods for private firms are improved
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
vi
List of Tables Table 421-1 Bank of Communications 34
Table 421-2 CITIC Bank 34
Table 421-3 China Merchants Bank 35
Table 421-4 Shanghai Pudong Development Bank 35
Table 422-1 Agricultural Bank of China 36
Table 422-2 Bank of China 36
Table 422-3 China Construction Bank 37
Table 422-4 Industrial and Commercial Bank of China 37
Table 431-1 Summary of SPDB New Shares Issue Prices 41
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value 47
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value 48
Table 451-1 Bank of Communications 49
Table 451-2 CITIC Bank 49
Table 451-3 China Merchants Bank 50
Table 451-4 Shanghai Pudong Development Bank 50
Table 452-1 Agricultural Bank of China 51
Table 452-2 Bank of China 51
Table 452-3 China Construction Bank 52
Table 452-4 Industrial and Commercial Bank of China 52
vii
List of Figures Figure 46-1 Comparative discrepancy between market price and intrinsic value of non-
state-owned banks 55
Figure 46-2 Comparative discrepancy between market price and intrinsic value of state-
owned banks 56
1
I Introduction
11 Background and Motivation Greed is said to be a cardinal sin and yet it seems to be a recurring theme through the
ages Humanityrsquos tendency to succumb to ldquothe love of moneyrdquo1 can be seen from the
tulip mania in the mid-16th century the Wall Street Crash of 1929 continuing through
the 1987 ldquoBlack Mondayrdquo the Asian Financial Crisis Enron and the most recent sub-
prime collapse and subsequent Global Financial Crisis (GFC) (Sargent 2008) The world
has been rocked by one financial scandal after another
In 2001 the Enron accounting scandal and the subsequent failure of several other firms
such as WorldCom lead to the disgrace of the accounting firm Arthur Anderson (Healy
amp Palepu 2003) The sub-prime crisis and ensuing GFC can be linked to reckless
lending practices that led to the collapse of financial institutions such as Bear Stearns
Merrill Lynch and Lehman Brothers (Wei amp Corkery 2008) It seems that the financial
world does not learn from its mistakes
In light of such recent crisis the stability of the world financial system is called into
question Chinarsquos economy appears to have ridden out the storm well and ldquois an engine
of growthrdquo for the rest of the world (Ezrati 2010) The PRC has been credited with
leading the world out of the recent global recession and in 2010 surpassed Japan as the
worldrsquos second-largest economy (Hamlin amp Yanping 2010) So what is underlying the
Chinese economy
1 New Testament The love of money is the root of all evil (1 Timothy 610 KJV)
2
While Chinarsquos future influence on the global economy will undoubtedly increase this
should be tempered with an understanding that China is still a developing nation
Chinarsquos current financial system is dominated by a large banking sector that has been
accused of being inefficient and poorly regulated (Allen Qian Zhang amp Zhao 2010) If
China falters how will the world economy be affected What if the Chinese financial
system were to suffer a crisis similar to the sub-prime collapse Is this likely
As Chris Browne (2007) writes China is still a communist country The government
owns or controls many of the listed and traded companies on the Shanghai Shenzhen and
Hong Kong stock exchanges Investors are a silent partner with no recourse should the
government decide to change policies
ldquoBy market capitalisation it[China] has three of the four largest banks the two largest
insurance companies the second-largest stock market and a lengthening list of
investment fundsrdquo (Economist 2010) Chinese companies are coming to dominate the
financial markets of the world In fact the Industrial and Commercial Bank of China
(ICBC) is ranked the worldrsquos largest bank by assets and valuation while still majority
state-owned (Hamlin amp Yanping 2010) Is this a cause for concern
What does market capitalization mean According to Berk and DeMarzo (2007) market
capitalization is ldquothe total dollar market value of all of a companys outstanding
shares Market capitalization is calculated by multiplying a companys shares outstanding
by the current market price of one sharerdquo The investment community uses this figure in
determining a companys size as opposed to sales or total asset figures Given the
3
speculative nature of Chinarsquos developing securities markets (Wang amp Xu 2004) (Liu amp
Shrestha 2008) does this market capitalization figure represent the true value of the bank
Perhaps Hollywood producer Oliver Stone had good cause to revive his character
Gordon Gekko of the 1987 film Wall Street to play the antihero of the 2010 sequel
Gekko reminds us all the lessons to be learned from the mantra of Wall Street ldquoGreed is
goodrdquo It seems the cardinal rule of capitalism is that an item is worth what people will
pay but is the willingness of buyers to pay high prices a reliable indicator of value
12 Purpose of the Research The purpose of this paper is to apply appropriate valuation methodologies in an attempt
to measure the intrinsic value of Chinarsquos banks independently of their market price The
aim is to examine valuation techniques with a focus on a practical issue of creating a
valuation range rather than a single lsquoprecisersquo number
By examining the value range of the banks in comparison to their market prices we can
determine if a margin of safety exists and estimate the risk that must be assumed if
investing in Chinarsquos banks This research is of importance to anyone considering
investing in China from Institutional Investors to executives considering Mergers and
Acquisitions The research would play a key role in corporate finance as valuations can
be used to assist in value enhancing financial decisions and corporate strategies
The study is based on banks listed on the Chinese stock exchanges The data were
collected from annual reports extracted from websites and financial databases The
scope of the research is where possible for the previous five years of company financial
4
data including the year 2010 The data on each banks market price for comparison were
sourced from the Shanghai Exchange database
13 Research Scope and Object In this study the scope of the research was confined to the top four ranked state-owned
and non-state owned commercial banks These banks are highly visible in the market and
due to Chinarsquos acceptance into the World Trade Organization (WTO) in 2001 it is
assumed that their financial data is the easiest to source and potentially the most
transparent
Various valuation techniques were applied to establish a range of values for the selected
banks to use in comparison with their listed market prices The importance of this effort
is to establish if Chinese banks are undervalued overvalued or valued accordingly
These valuation figures will be used to test the research hypotheses
14 Significance of the Research This research adds to the existing body of knowledge regarding the valuation of banks
and in particular the value of the Chinese banks in the developing Chinese securities
markets
The Montgomery valuation method studied here also has potential uses for valuing
private firms There is a need to establish a more accurate method to value private firms
for initial public offerings mergers and acquisitions and so forth With the results of this
research and previous works such as Pratt et al (200) Thavikulwat (2004) and King
(2010) it is hoped that the valuation methods for private firms are improved
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
vii
List of Figures Figure 46-1 Comparative discrepancy between market price and intrinsic value of non-
state-owned banks 55
Figure 46-2 Comparative discrepancy between market price and intrinsic value of state-
owned banks 56
1
I Introduction
11 Background and Motivation Greed is said to be a cardinal sin and yet it seems to be a recurring theme through the
ages Humanityrsquos tendency to succumb to ldquothe love of moneyrdquo1 can be seen from the
tulip mania in the mid-16th century the Wall Street Crash of 1929 continuing through
the 1987 ldquoBlack Mondayrdquo the Asian Financial Crisis Enron and the most recent sub-
prime collapse and subsequent Global Financial Crisis (GFC) (Sargent 2008) The world
has been rocked by one financial scandal after another
In 2001 the Enron accounting scandal and the subsequent failure of several other firms
such as WorldCom lead to the disgrace of the accounting firm Arthur Anderson (Healy
amp Palepu 2003) The sub-prime crisis and ensuing GFC can be linked to reckless
lending practices that led to the collapse of financial institutions such as Bear Stearns
Merrill Lynch and Lehman Brothers (Wei amp Corkery 2008) It seems that the financial
world does not learn from its mistakes
In light of such recent crisis the stability of the world financial system is called into
question Chinarsquos economy appears to have ridden out the storm well and ldquois an engine
of growthrdquo for the rest of the world (Ezrati 2010) The PRC has been credited with
leading the world out of the recent global recession and in 2010 surpassed Japan as the
worldrsquos second-largest economy (Hamlin amp Yanping 2010) So what is underlying the
Chinese economy
1 New Testament The love of money is the root of all evil (1 Timothy 610 KJV)
2
While Chinarsquos future influence on the global economy will undoubtedly increase this
should be tempered with an understanding that China is still a developing nation
Chinarsquos current financial system is dominated by a large banking sector that has been
accused of being inefficient and poorly regulated (Allen Qian Zhang amp Zhao 2010) If
China falters how will the world economy be affected What if the Chinese financial
system were to suffer a crisis similar to the sub-prime collapse Is this likely
As Chris Browne (2007) writes China is still a communist country The government
owns or controls many of the listed and traded companies on the Shanghai Shenzhen and
Hong Kong stock exchanges Investors are a silent partner with no recourse should the
government decide to change policies
ldquoBy market capitalisation it[China] has three of the four largest banks the two largest
insurance companies the second-largest stock market and a lengthening list of
investment fundsrdquo (Economist 2010) Chinese companies are coming to dominate the
financial markets of the world In fact the Industrial and Commercial Bank of China
(ICBC) is ranked the worldrsquos largest bank by assets and valuation while still majority
state-owned (Hamlin amp Yanping 2010) Is this a cause for concern
What does market capitalization mean According to Berk and DeMarzo (2007) market
capitalization is ldquothe total dollar market value of all of a companys outstanding
shares Market capitalization is calculated by multiplying a companys shares outstanding
by the current market price of one sharerdquo The investment community uses this figure in
determining a companys size as opposed to sales or total asset figures Given the
3
speculative nature of Chinarsquos developing securities markets (Wang amp Xu 2004) (Liu amp
Shrestha 2008) does this market capitalization figure represent the true value of the bank
Perhaps Hollywood producer Oliver Stone had good cause to revive his character
Gordon Gekko of the 1987 film Wall Street to play the antihero of the 2010 sequel
Gekko reminds us all the lessons to be learned from the mantra of Wall Street ldquoGreed is
goodrdquo It seems the cardinal rule of capitalism is that an item is worth what people will
pay but is the willingness of buyers to pay high prices a reliable indicator of value
12 Purpose of the Research The purpose of this paper is to apply appropriate valuation methodologies in an attempt
to measure the intrinsic value of Chinarsquos banks independently of their market price The
aim is to examine valuation techniques with a focus on a practical issue of creating a
valuation range rather than a single lsquoprecisersquo number
By examining the value range of the banks in comparison to their market prices we can
determine if a margin of safety exists and estimate the risk that must be assumed if
investing in Chinarsquos banks This research is of importance to anyone considering
investing in China from Institutional Investors to executives considering Mergers and
Acquisitions The research would play a key role in corporate finance as valuations can
be used to assist in value enhancing financial decisions and corporate strategies
The study is based on banks listed on the Chinese stock exchanges The data were
collected from annual reports extracted from websites and financial databases The
scope of the research is where possible for the previous five years of company financial
4
data including the year 2010 The data on each banks market price for comparison were
sourced from the Shanghai Exchange database
13 Research Scope and Object In this study the scope of the research was confined to the top four ranked state-owned
and non-state owned commercial banks These banks are highly visible in the market and
due to Chinarsquos acceptance into the World Trade Organization (WTO) in 2001 it is
assumed that their financial data is the easiest to source and potentially the most
transparent
Various valuation techniques were applied to establish a range of values for the selected
banks to use in comparison with their listed market prices The importance of this effort
is to establish if Chinese banks are undervalued overvalued or valued accordingly
These valuation figures will be used to test the research hypotheses
14 Significance of the Research This research adds to the existing body of knowledge regarding the valuation of banks
and in particular the value of the Chinese banks in the developing Chinese securities
markets
The Montgomery valuation method studied here also has potential uses for valuing
private firms There is a need to establish a more accurate method to value private firms
for initial public offerings mergers and acquisitions and so forth With the results of this
research and previous works such as Pratt et al (200) Thavikulwat (2004) and King
(2010) it is hoped that the valuation methods for private firms are improved
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
1
I Introduction
11 Background and Motivation Greed is said to be a cardinal sin and yet it seems to be a recurring theme through the
ages Humanityrsquos tendency to succumb to ldquothe love of moneyrdquo1 can be seen from the
tulip mania in the mid-16th century the Wall Street Crash of 1929 continuing through
the 1987 ldquoBlack Mondayrdquo the Asian Financial Crisis Enron and the most recent sub-
prime collapse and subsequent Global Financial Crisis (GFC) (Sargent 2008) The world
has been rocked by one financial scandal after another
In 2001 the Enron accounting scandal and the subsequent failure of several other firms
such as WorldCom lead to the disgrace of the accounting firm Arthur Anderson (Healy
amp Palepu 2003) The sub-prime crisis and ensuing GFC can be linked to reckless
lending practices that led to the collapse of financial institutions such as Bear Stearns
Merrill Lynch and Lehman Brothers (Wei amp Corkery 2008) It seems that the financial
world does not learn from its mistakes
In light of such recent crisis the stability of the world financial system is called into
question Chinarsquos economy appears to have ridden out the storm well and ldquois an engine
of growthrdquo for the rest of the world (Ezrati 2010) The PRC has been credited with
leading the world out of the recent global recession and in 2010 surpassed Japan as the
worldrsquos second-largest economy (Hamlin amp Yanping 2010) So what is underlying the
Chinese economy
1 New Testament The love of money is the root of all evil (1 Timothy 610 KJV)
2
While Chinarsquos future influence on the global economy will undoubtedly increase this
should be tempered with an understanding that China is still a developing nation
Chinarsquos current financial system is dominated by a large banking sector that has been
accused of being inefficient and poorly regulated (Allen Qian Zhang amp Zhao 2010) If
China falters how will the world economy be affected What if the Chinese financial
system were to suffer a crisis similar to the sub-prime collapse Is this likely
As Chris Browne (2007) writes China is still a communist country The government
owns or controls many of the listed and traded companies on the Shanghai Shenzhen and
Hong Kong stock exchanges Investors are a silent partner with no recourse should the
government decide to change policies
ldquoBy market capitalisation it[China] has three of the four largest banks the two largest
insurance companies the second-largest stock market and a lengthening list of
investment fundsrdquo (Economist 2010) Chinese companies are coming to dominate the
financial markets of the world In fact the Industrial and Commercial Bank of China
(ICBC) is ranked the worldrsquos largest bank by assets and valuation while still majority
state-owned (Hamlin amp Yanping 2010) Is this a cause for concern
What does market capitalization mean According to Berk and DeMarzo (2007) market
capitalization is ldquothe total dollar market value of all of a companys outstanding
shares Market capitalization is calculated by multiplying a companys shares outstanding
by the current market price of one sharerdquo The investment community uses this figure in
determining a companys size as opposed to sales or total asset figures Given the
3
speculative nature of Chinarsquos developing securities markets (Wang amp Xu 2004) (Liu amp
Shrestha 2008) does this market capitalization figure represent the true value of the bank
Perhaps Hollywood producer Oliver Stone had good cause to revive his character
Gordon Gekko of the 1987 film Wall Street to play the antihero of the 2010 sequel
Gekko reminds us all the lessons to be learned from the mantra of Wall Street ldquoGreed is
goodrdquo It seems the cardinal rule of capitalism is that an item is worth what people will
pay but is the willingness of buyers to pay high prices a reliable indicator of value
12 Purpose of the Research The purpose of this paper is to apply appropriate valuation methodologies in an attempt
to measure the intrinsic value of Chinarsquos banks independently of their market price The
aim is to examine valuation techniques with a focus on a practical issue of creating a
valuation range rather than a single lsquoprecisersquo number
By examining the value range of the banks in comparison to their market prices we can
determine if a margin of safety exists and estimate the risk that must be assumed if
investing in Chinarsquos banks This research is of importance to anyone considering
investing in China from Institutional Investors to executives considering Mergers and
Acquisitions The research would play a key role in corporate finance as valuations can
be used to assist in value enhancing financial decisions and corporate strategies
The study is based on banks listed on the Chinese stock exchanges The data were
collected from annual reports extracted from websites and financial databases The
scope of the research is where possible for the previous five years of company financial
4
data including the year 2010 The data on each banks market price for comparison were
sourced from the Shanghai Exchange database
13 Research Scope and Object In this study the scope of the research was confined to the top four ranked state-owned
and non-state owned commercial banks These banks are highly visible in the market and
due to Chinarsquos acceptance into the World Trade Organization (WTO) in 2001 it is
assumed that their financial data is the easiest to source and potentially the most
transparent
Various valuation techniques were applied to establish a range of values for the selected
banks to use in comparison with their listed market prices The importance of this effort
is to establish if Chinese banks are undervalued overvalued or valued accordingly
These valuation figures will be used to test the research hypotheses
14 Significance of the Research This research adds to the existing body of knowledge regarding the valuation of banks
and in particular the value of the Chinese banks in the developing Chinese securities
markets
The Montgomery valuation method studied here also has potential uses for valuing
private firms There is a need to establish a more accurate method to value private firms
for initial public offerings mergers and acquisitions and so forth With the results of this
research and previous works such as Pratt et al (200) Thavikulwat (2004) and King
(2010) it is hoped that the valuation methods for private firms are improved
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
2
While Chinarsquos future influence on the global economy will undoubtedly increase this
should be tempered with an understanding that China is still a developing nation
Chinarsquos current financial system is dominated by a large banking sector that has been
accused of being inefficient and poorly regulated (Allen Qian Zhang amp Zhao 2010) If
China falters how will the world economy be affected What if the Chinese financial
system were to suffer a crisis similar to the sub-prime collapse Is this likely
As Chris Browne (2007) writes China is still a communist country The government
owns or controls many of the listed and traded companies on the Shanghai Shenzhen and
Hong Kong stock exchanges Investors are a silent partner with no recourse should the
government decide to change policies
ldquoBy market capitalisation it[China] has three of the four largest banks the two largest
insurance companies the second-largest stock market and a lengthening list of
investment fundsrdquo (Economist 2010) Chinese companies are coming to dominate the
financial markets of the world In fact the Industrial and Commercial Bank of China
(ICBC) is ranked the worldrsquos largest bank by assets and valuation while still majority
state-owned (Hamlin amp Yanping 2010) Is this a cause for concern
What does market capitalization mean According to Berk and DeMarzo (2007) market
capitalization is ldquothe total dollar market value of all of a companys outstanding
shares Market capitalization is calculated by multiplying a companys shares outstanding
by the current market price of one sharerdquo The investment community uses this figure in
determining a companys size as opposed to sales or total asset figures Given the
3
speculative nature of Chinarsquos developing securities markets (Wang amp Xu 2004) (Liu amp
Shrestha 2008) does this market capitalization figure represent the true value of the bank
Perhaps Hollywood producer Oliver Stone had good cause to revive his character
Gordon Gekko of the 1987 film Wall Street to play the antihero of the 2010 sequel
Gekko reminds us all the lessons to be learned from the mantra of Wall Street ldquoGreed is
goodrdquo It seems the cardinal rule of capitalism is that an item is worth what people will
pay but is the willingness of buyers to pay high prices a reliable indicator of value
12 Purpose of the Research The purpose of this paper is to apply appropriate valuation methodologies in an attempt
to measure the intrinsic value of Chinarsquos banks independently of their market price The
aim is to examine valuation techniques with a focus on a practical issue of creating a
valuation range rather than a single lsquoprecisersquo number
By examining the value range of the banks in comparison to their market prices we can
determine if a margin of safety exists and estimate the risk that must be assumed if
investing in Chinarsquos banks This research is of importance to anyone considering
investing in China from Institutional Investors to executives considering Mergers and
Acquisitions The research would play a key role in corporate finance as valuations can
be used to assist in value enhancing financial decisions and corporate strategies
The study is based on banks listed on the Chinese stock exchanges The data were
collected from annual reports extracted from websites and financial databases The
scope of the research is where possible for the previous five years of company financial
4
data including the year 2010 The data on each banks market price for comparison were
sourced from the Shanghai Exchange database
13 Research Scope and Object In this study the scope of the research was confined to the top four ranked state-owned
and non-state owned commercial banks These banks are highly visible in the market and
due to Chinarsquos acceptance into the World Trade Organization (WTO) in 2001 it is
assumed that their financial data is the easiest to source and potentially the most
transparent
Various valuation techniques were applied to establish a range of values for the selected
banks to use in comparison with their listed market prices The importance of this effort
is to establish if Chinese banks are undervalued overvalued or valued accordingly
These valuation figures will be used to test the research hypotheses
14 Significance of the Research This research adds to the existing body of knowledge regarding the valuation of banks
and in particular the value of the Chinese banks in the developing Chinese securities
markets
The Montgomery valuation method studied here also has potential uses for valuing
private firms There is a need to establish a more accurate method to value private firms
for initial public offerings mergers and acquisitions and so forth With the results of this
research and previous works such as Pratt et al (200) Thavikulwat (2004) and King
(2010) it is hoped that the valuation methods for private firms are improved
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
3
speculative nature of Chinarsquos developing securities markets (Wang amp Xu 2004) (Liu amp
Shrestha 2008) does this market capitalization figure represent the true value of the bank
Perhaps Hollywood producer Oliver Stone had good cause to revive his character
Gordon Gekko of the 1987 film Wall Street to play the antihero of the 2010 sequel
Gekko reminds us all the lessons to be learned from the mantra of Wall Street ldquoGreed is
goodrdquo It seems the cardinal rule of capitalism is that an item is worth what people will
pay but is the willingness of buyers to pay high prices a reliable indicator of value
12 Purpose of the Research The purpose of this paper is to apply appropriate valuation methodologies in an attempt
to measure the intrinsic value of Chinarsquos banks independently of their market price The
aim is to examine valuation techniques with a focus on a practical issue of creating a
valuation range rather than a single lsquoprecisersquo number
By examining the value range of the banks in comparison to their market prices we can
determine if a margin of safety exists and estimate the risk that must be assumed if
investing in Chinarsquos banks This research is of importance to anyone considering
investing in China from Institutional Investors to executives considering Mergers and
Acquisitions The research would play a key role in corporate finance as valuations can
be used to assist in value enhancing financial decisions and corporate strategies
The study is based on banks listed on the Chinese stock exchanges The data were
collected from annual reports extracted from websites and financial databases The
scope of the research is where possible for the previous five years of company financial
4
data including the year 2010 The data on each banks market price for comparison were
sourced from the Shanghai Exchange database
13 Research Scope and Object In this study the scope of the research was confined to the top four ranked state-owned
and non-state owned commercial banks These banks are highly visible in the market and
due to Chinarsquos acceptance into the World Trade Organization (WTO) in 2001 it is
assumed that their financial data is the easiest to source and potentially the most
transparent
Various valuation techniques were applied to establish a range of values for the selected
banks to use in comparison with their listed market prices The importance of this effort
is to establish if Chinese banks are undervalued overvalued or valued accordingly
These valuation figures will be used to test the research hypotheses
14 Significance of the Research This research adds to the existing body of knowledge regarding the valuation of banks
and in particular the value of the Chinese banks in the developing Chinese securities
markets
The Montgomery valuation method studied here also has potential uses for valuing
private firms There is a need to establish a more accurate method to value private firms
for initial public offerings mergers and acquisitions and so forth With the results of this
research and previous works such as Pratt et al (200) Thavikulwat (2004) and King
(2010) it is hoped that the valuation methods for private firms are improved
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
4
data including the year 2010 The data on each banks market price for comparison were
sourced from the Shanghai Exchange database
13 Research Scope and Object In this study the scope of the research was confined to the top four ranked state-owned
and non-state owned commercial banks These banks are highly visible in the market and
due to Chinarsquos acceptance into the World Trade Organization (WTO) in 2001 it is
assumed that their financial data is the easiest to source and potentially the most
transparent
Various valuation techniques were applied to establish a range of values for the selected
banks to use in comparison with their listed market prices The importance of this effort
is to establish if Chinese banks are undervalued overvalued or valued accordingly
These valuation figures will be used to test the research hypotheses
14 Significance of the Research This research adds to the existing body of knowledge regarding the valuation of banks
and in particular the value of the Chinese banks in the developing Chinese securities
markets
The Montgomery valuation method studied here also has potential uses for valuing
private firms There is a need to establish a more accurate method to value private firms
for initial public offerings mergers and acquisitions and so forth With the results of this
research and previous works such as Pratt et al (200) Thavikulwat (2004) and King
(2010) it is hoped that the valuation methods for private firms are improved
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
5
The significance of the results is that it provides an alternative valuation method by
combining the Montgomery Method with existing valuation techniques The fact that the
combination is simple to use makes it more possible for analysts to test and apply the
results found by this research More specifically if the results are consistent with possible
future research this may become another valuation method that is established in valuing
companies
15 Research Process The process of this research is as follows
1 Definition of study purpose
Based on the background and motivation of this study to establish the purpose
of this research
2 Literature and theoretical review
Review extant literature and theories regarding the banking industry more
specifically Chinarsquos banks and valuation methodologies
3 Research Framework
Apply the relevant extant literature and theories to determine appropriate
valuation models for the Chinese banking industry
4 Collection of appropriate financial data
Gather the appropriate financial data for each of the selected banks for the
past five years primarily sourced from annual reports
5 Data Analysis
Apply various relevant valuation models to analyze the financial data
6 Test Hypothesis
Apply analysis of valuation models to test hypotheses
7 Conclusions and recommendations
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
6
Interpret the results of the data analysis state conclusions and provide
recommendations
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
7
II Literature Review This section reviews the literature regarding Chinarsquos financial system exploring its
banking system and securities market Key performance indicators for banks are also
discussed as is the role of profit in a transitioning economy Various definitions of value
are reviewed and the reasons for and approaches to valuation are considered
21 Chinarsquos Financial System China is considered a rapidly developing country with boundless opportunities yet
Chinarsquos potential is still relatively unknown How much does the rest of the world know
about China The government is still run by the Communist Party of China (CPC) and
the majority of publicly traded companies were once (and still are) majority state-owned
One can look at various sources such as the Chinese stock market and check the prices of
many of its listed companies but how can you know the value of these companies How
can anyone invest in China without having a sense of the value of the investment
211 Chinese Banking Industry As China has moved from a planned economy to a market economy many of its
industries have moved from monopoly positions towards more direct competition The
banking industry of China is a good example of this transition
212 Monopoly to Competition ldquoBetween 1950 and 1978 Chinarsquos financial system consisted of a single bank ndash the
Peoplersquos Bank of China (PBOC) a central government-owned and controlled bank under
the Ministry of Financerdquo(Brandt amp Rawski 2008) Due to government restrictions the
PBOC was a monopoly its main role was to finance physical production plans
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
8
controlling about 93 percent of the total financial assets of the country and handling
almost all financial transactions (Berger Hasan amp Zhou 2008)
As China began its transition in 1978 from a planned economy to a market economy the
role of the PBOC changed PBOC was formally established as Chinarsquos central bank and
four state-owned banks took over the majority of commercial banking business in a
gradual process from the PBOC Berger et al (2008) continues stating that Chinas
current banking reform includes partially privatizing its dominant Big Four state-owned
banks and taking on minority foreign ownership of these institutions Other state-owned
banks are also engaging in this practice A key finding of Berger et al (2008) was that the
Big Four state-owned banks are by far the least efficient and that minority foreign
ownership of other banks is associated with significantly improved efficiency
ldquoSince the process of economic reform began in China the Chinese banking system has
grown impressively the state-owned commercial banks (SCB) continue to dominate the
market as of the end of June 2003 the four SCBs held 65 of deposits provided 80 of
all payment and settlement services and accounted for 56 of all loans granted by
financial institutions in China However the share of the market held by the shareholding
commercial banks has grown substantially in the last few years By the end of June 2003
these banks controlled 136 of total financial sector assetsrdquo (Wu amp Chen 2010)
Allen et al (2010) state that even with the entrance and growth of many domestic and
foreign banks and financial institutions in recent years Chinarsquos banking system is still
mainly controlled by the four largest state-owned banks with over 50 percent share of
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
9
total banking assets between them2 All of these ldquoBig Fourrdquo banks have become publicly
listed and traded companies in recent years with the government being the largest
shareholder and retaining control
213 Non-State-Owned Commercial Banks Wen (2008) defines 12 commercial banks in China as ldquonon-state-owned commercial
banksrdquo To be considered a ldquonon-state-owned commercial banksrdquo these 12 commercial
banks must meet several criteria First each of them has an approval from Chinese
banking regulators to operate as nationwide commercial banks Second they are
commercial banks that are not owned by the state government These banks are also
called non-state-owned joint-stock commercial banks in China (JSCBs) The state
controlled entities are those over which the PRC government directly holds over 50 of
the outstanding shares or voting rights and has the ability to control or the power to
govern their financial or operational policies such as the Agricultural Bank of China and
other big four banks
Only seven non-state-owned Chinese commercial banks are listed in the two national
stock exchanges in mainland China-Shanghai Stock Exchange and Shenzhen Stock
Exchange Most of the listed non-state-owned Chinese commercial banks prefer to
choose the primary domestic stock exchange in Shanghai (Wen 2008)
214 Key Performance Indicators (KPIs) for Banks Ho and Wu (2006) state that the performance criteria commonly used in financial
analysis are liquidity asset utilization leverage profitability growth and stock
2 Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 739 percent of the total assets in 1993 and 546 percent in 2004 and remain at this level currently) Peoples Bank of China Financial Stability Report 2010 - Source Peoples Bank of China
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
10
performance In their study to establish benchmark performance indicators for Australian
banks Ho and Wu (2006) adopted financial statement analysis to select ratios The ratios
were classified in accordance with their respective attributes under the six categories
profitability asset utilization leverage liquidity growth and stock performance
Ho and Wu (2006) determined 13 ratios for analyzing the profitability factor 16 for
leverage eight for liquidity two for asset utilization 12 for growth and eight for stock
performance In total 59 financial ratios were selected as the aggregated indicators for
evaluating the performance of the banks Browne (2007) advises that price to book value
price to earnings and price to net current assets are among those ratios important to
valuing a company Whereas Montgomery (2010) stresses that return on equity is the
most important ratio to consider
215 Profit versus Profitability McGuigan et al (2007) state that in a free enterprise system profits play an important
role in guiding the decisions made by resource owners Profit and profit opportunities
play a major role in determining the efficient allocation of resources in any market
economy Without the market signals that profit gives it would be necessary to develop
alternative schemes on which to base resource-allocation decisions These alternatives
are often bureaucratic and frequently lack the responsiveness to changing market
conditions that a free enterprise system provides
In addition to the role of profit in capital allocation risk bearing is also a factor The risk
bearing theory of profit suggests that there is a need for profit above a competitive rate of
return necessary to compensate the owners of the firm for the risk they assume when
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
11
making their investments (McGuigan Moyer amp Harris 2007) However the majority
ownership of the Chinese banking industry is still in the governmentrsquos hands
Economic theory assumes that the objective of a firm is to maximize shareholder wealth
This creates an interesting dilemma In an agency relationship the owners frequently
delegate decision-making authority to professional managers Because the managers
(agents) have much less to lose than the owners (principals) the agents often seek
acceptable levels (rather than a maximum) of profit and shareholder wealth while
pursuing their own self-interests (Westort Kashian amp Cummings 2010) As the majority
owners are a communist government do the state-owned banks aim to maximize profits
Should that even be a concern
Montgomery (2010) provides the following example as a thought exercise Imagine you
own a business that you initially invest $10 million dollars and never invest another cent
into it In its first year it earns you $1 million profit the next year $2 million then $3
then $7 and then $10 million Consider its desirability
Now suppose you own a different business that requires the same initial investment and
produces the same series of profits There is one difference The second business
requires you to reinvest half the profits back into the business each year to keep it
successful against its competitors
Which business would you prefer to own The first business is more desirable He refers
to the effect on the second business as inhibited earnings basically more capital is
required to generate the same level of profits The second business is therefore less
profitable
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
12
Montgomery (2010) argues that while profits are important the amount of equity
required to generate that profit is of greater importance A companyrsquos profit figure can
bear little resemblance to cash profits or cash flow It is the profitability of a company
that should be considered in evaluating the value of a company
216 Speculative Securities Market Chinarsquos two domestic stock exchanges the Shanghai Stock Exchange (SHSE) and
Shenzhen Stock Exchange (SZSE) were established in 1990 (Allen Qian Zhang amp
Zhao 2010) Their scale and importance are not comparable to the banking sector and
they have ldquonot been effective in allocating resources in the economy in that they are
highly speculative and driven by insider tradingrdquo (Berger Hasan amp Zhou 2008)
Wang and Xu (2010) argue that with the sustainable development of Chinas economy
Chinas securities market would play a more and more important role in the global
securities market However as an emerging market the speculative psychology and
short-term investing behavior in Chinas securities market is clearly visible and therefore
it is of important theoretical and practical significance to research on behavioral finance
features of Chinas securities market
Liu and Shrestha (2008) discuss how numerous studies have analyzed how stock prices
react to changes in macro-economic variables Some studies for example examined the
impact of individual factors such as inflation market dynamics and interest rates on stock
prices (Fama 1981 1990 Mandelker and Tandon 1985 Bulmash and Trivoli 1991
Asprem 1989 Schwert 1990 Mukherjee and Naka 1995) Others on the other hand
examined the relationship between stock prices and a wider variety of financial and
macro-economic variables (Chen et al 1986 Fama and French 1989 Cheung and Ng
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
13
1998) However the studies mentioned all focus on stock markets in developed countries
Limited research has been performed on the stock markets in developing countries such
as China
The literature on the stock markets of China is limited in scope This study is also
motivated by the fact that the Chinese stock market is very different from others
especially in terms of the extent of government regulations and the investor composition
(Allen Qian Zhang amp Zhao 2010) In China financial data of listed companies
(especially small firms) are not reliable Bankruptcies are rare and the standards of
corporate governance are very low (Brandt amp Rawski 2008)
Allen et al (2010) expands that the regulatory framework for the stock market is not fully
developed and information available to investors is not always transparent Allen et al
(2010) also asserts that individual investors constitute approximately 99 per cent of the
investors in the Chinese stock market With little investment knowledge or experience
they trade like noise traders3 and purely speculate in the stock market in the absence of
market transparency The result is stock market mania
Another interesting feature of the Chinese stock market is that almost all listed firms are
formerly state-owned enterprises (SOEs) 4 The privatization process involves
restructuring the companies into incorporated companies through selling a certain
proportion of shares to employees the general public other SOEs and legal entities such
3 The term used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data 4 At the end of the 1990s more than 90 percent of the enterprises listed on Chinarsquos two stock exchanges remained state controlled with state-owned entities as their controlling shareholders and as of 2002 only 15 percent of stocks are associated with private corporations Many companies have state-owned parent companies that are not listed and are hybrids of public and private enterprises in which the government floats minority interests to raise money while retaining the bulk of shares
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
14
as banks and insurance companies etc at a price around book value per share Typically
shares owned by legal entities and the remaining shares held by the state (ie by local or
central government) account for two-thirds of the total number of shares and they are not
allowed to be traded As a result only one-third of the shares are allowed to be traded
(Liu amp Shrestha 2008)
Kang Liu and Ni (2002) write that the Chinese stock market is also driven by liquidity
As there is no well-developed social security system in China the savings rate is among
the highest in the world Bank interest rates are regulated by the government and often
kept low for the purpose of economic development resulting in negative real interest
rates Further all the property is owned by the state and property investment was not
allowed until recently with the results that the stock market is the natural choice for
investors who are looking for higher rate of returns despite the high risks involved
A speculative securities market suggests that market prices do not represent the true value
of the listed security Analysts and local investors seem to be more focused on short term
earnings gains than future long term success
22 Valuation scope What is value The definition of ldquovaluerdquo varies in the economic literature Depending on the context
there are several standards of value these include
Market Value
Fair Value
Book Value
Investment Value
Intrinsic Value
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
15
These standards of value are defined as follows
221 Market Value ldquoThe price expressed in terms of cash equivalents at which property would change
hands between a hypothetical willing and able buyer and a hypothetical willing and able
seller acting at armrsquos length in an open and unrestricted market when neither is under
compulsion to buy or sell and when both have reasonable knowledge of the relevant
factsrdquo International Glossary of Business and Valuation Terms (International Glossary)
(2001)
222 Fair Value ldquoThe amount at which an asset (or liability) could be bought (or incurred) or sold (or
settled) in a current transaction between willing parties that is other than in a forced or
liquidation salerdquo (Hitchner 2003) or more directly ldquothe term fair value is usually a
legally created standard of value that applies to certain specific transactionsrdquo (Pratt
Reilly amp Schweihs 2000)
223 Book Value ldquoWith respect to a business enterprise the difference between total assets (net of
accumulated depreciation depletion and amortization) and total liabilities as they appear
on the balance sheet (synonymous with Shareholders Equity)rdquo International Glossary
(2001)
It is important to note that the firmrsquos book value may be an unreasonable measure of its
true value because of the idiosyncrasies of accounting
224 Investment Value The International Glossary defines investment value as ldquoThe value to a particular
investor based on individual investment requirements and expectationsrdquo Hitchner (2003)
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
16
adds that investment value is the value to a particular investor which reflects the
particular and specific attributes of that investor In the case of a stock exchange an
auction setting is created in which each bidder is likely to offer a different price based on
their individual outlook and the synergies that each bidder brings to the transaction
225 Intrinsic Value Hitchner (2003) defines intrinsic value as the ldquoamount an investor considers to be the
lsquotruersquo or lsquorealrsquo worth of an item based on an evaluation of available facts hellip It is an
analytical judgment of value based on perceived characteristics inherent to the
investmentrdquo
Graham et al (1988) states a general definition of intrinsic value would be ldquothat value
which is justified by the facts eg assets earning dividends definite prospects
including the factor of managementrdquo Given the dynamic nature of business the primary
objective is to emphasize the distinction between ldquovalue and current market price but not
to invest lsquovaluersquo with an aura of permanencerdquo
For companies and various investment alternatives (such as bonds) their value is intrinsic
because it is generated by the underlying operations of the enterprise in the form of
earnings dividends and cash flows The concept of intrinsic value is the actual worth of
a security as opposed to its market or book value and so on For example intrinsic value
may differ from market value because of brand names patents and other intangibles that
are difficult for investors to quantify
In that case value is measured by its assessed qualities or by the esteem in which it is
held If intrinsic value is the actual worth of a company or an asset based on an
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
17
underlying perception of its true value including all aspects of the business in terms of
both tangible and intangible factors then what are the measurable qualities that create
value for a company
There are various approaches but no standard formula exists for calculating the intrinsic
value of an asset As value can vary from individual to individual due to differing
perceptions how does that affect the way in which a business is valued
23 Valuation objective Why value companies While computers can run simulations and compute numerous mathematical investment
models the fact remains that for the foreseeable future individuals are still responsible
for most major investment decisions This can be better summarized by Benjamin
Graham who said
ldquoInvesting like medicine law and economics lies somewhere between an art and
a science Certain aspects of investing lend themselves to the scientific approach but
corporations are still business enterprises subject to the vagaries of human management
and operate in highly dynamic and competitive environments As a result for the
security analyst the number of variables remains almost infinite and the judgment factor
still dominates investment decisionsrdquo (Graham Dodd Cottle Murray amp Block 1988)
The efficient market theory states that since the stock market is so quick to adjust to new
information security prices very quickly represent all the information available This is
not a realistic tenet investors tend to fall prey to their emotions and as a group may
decrease a stock price below intrinsic value when bad news reaches them Conversely
they tend to increase stock prices to levels above intrinsic value upon hearing good news
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
18
As such human behavior cannot be modeled with mathematics There is no computer
model that can predict whether someone will buy or sell their securities or at what price
The uncertainty will always be there It cannot be calculated Risk and reward are beyond
the intellectual limits of a computer A buyer must decide on a fair value before making
a bid and a seller must determine whether the bid is a reasonable value before deciding to
accept or reject the offer
Valuation has many subjective factors which lead to many differences of opinion This
can be summed up in the English expression ldquoone manrsquos trash is another manrsquos treasurerdquo
Every time there is a trade of stock there is a difference of opinion the buyer thinks the
stock is worth having and the seller does not
The problem in valuation is not that there are not enough models for valuations it is that
there are too many This leads to the dilemma of which model(s) to use
231 Valuation is not an exact science ldquoValuation rests on assumptions By definition the choice of assumptions in a valuation
report requires the professional judgment of the valuatorhellip The value can be higher or
lower if certain critical assumptions are changedrdquo (King 2010)
King (2010) continues stating that readers of financial statements expect exact answers
They see numbers and think of math an exact science failing to realize however that
most companies round to the nearest thousand and in some cases million dollars in their
financials
So the question becomes if valuations are not exact why are they performed In short
because valuation matters It underpins a major proportion of financial decisions in
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
19
mature economies From mergers and acquisitions to institutional investors failure to
properly understand the position and worth of a business risks financial exposure for a
wide range of stakeholders Valuations enable investors and executives to make more
informed decisions regarding the use of capital
Graham et al (1988) advocate that security analysis and valuation does not seek to
determine exactly what is the intrinsic value of a given security It needs only to establish
either that the value is adequate (eg to protect a bond or to justify a stock purchase) or
else that the value is considerably higher or considerably lower than the market price
Without an assessment of value price dictates an investorrsquos view of worth An estimated
value creates a reference point in which to compare with price This comparison can then
be used to base an investment decision to buy sell or hold
232 Bargains and Value Studies of market efficiencies modern portfolio theory and the insights from financial
economics argue that for all investors or for the average investor there are no consistent
returns to be earned from security analysis (Graham 2003) Supposedly the marketrsquos
pricing mechanism fueled by the efforts of capable analysts is too efficient to afford
opportunities even for some investors to earn superior returns from security portfolios
ldquoThe Graham and Dodd approach however takes the view that the marketrsquos pricing
mechanism remains based to such a degree upon faulty and frequently irrational
analytical processes that the price of a security only occasionally coincides with the
intrinsic value around which it tends to fluctuaterdquo (Graham Dodd Cottle Murray amp
Block 1988)
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
20
In everyday life we talk about ldquogetting value for moneyrdquo What we mean when we use
this phrase is paying less for something than we think it is worth When we use this
everyday expression we are distinguishing between the concept of value and price
Value is what we get and the price is what we pay
Most people are bargain hunters When their favourite grocery items go on sale they buy
more Their behavior in the stock market appears to be the opposite When share prices
fall investors are afraid to enter the market Without knowing the value of a business it
is difficult to know if the investment is a bargain If there is a discrepancy between price
and value then bargains can be found But can businesses (or a part ownership of those
businesses) be bought at a bargain price Proponents of the Efficient Market Hypothesis
(EMH) would say ldquonordquo Benjamin Graham ndash often referred to as the father of ldquovalue
investingrdquo and followers of his teachings would say ldquoyesrdquo
Value investing is in effect predicated on the proposition that the efficient-market
hypothesis is frequently wrong In the short run the market prices of good companies can
go down and bad companies can go up But over the long term share prices converge
with intrinsic value At the core of its success is the recurrent mispricing of securities in
the marketplace By finding securities whose prices depart increasingly from underlying
value investors can achieve above-average returns while taking below-average risks
24 Valuation methods How can companies be valued There is a substantial body of literature discussing different methods applied to valuation
(Graham et al 1988 Hitchner 2003 King 2010 Thavikulwat 2004 Nielsen and
Hudson 1987 Lokey and Masson 1987 and Damodaran 1994) The general consensus
among authors is that three general categories exist to value companies These categories
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
21
are based on future economic use earnings (income) comparable sales in the market
(market) or replacement costs (asset)
Income Approach
Market Approach
Asset Approach
Each of the above approaches has a variety of methods that can be independently applied
to valuation However no one of them is perfect Researchers can only choose a method
that has the least amount of drawbacks for the studyrsquos particular situation The following
are a selection of the various valuation methods grouped and defined including pros and
cons of each method
241 Income Approach The income approach is typically calculated using the discounted future-earnings method
or a derivative of such It works by discounting through the use of an appropriate rate
the estimated future earnings (net cash flows) for a specific number of years (Nielsen amp
Hudson 1987)
According to this standard stock valuation model the determinants of stock price are the
expected cash flows from the stock and the required rate of return commensurate with the
cash flows riskiness Asquith et al (2005) examined analysts reports issued during 1997-
1999 They document that 991 percent of analysts mention the use of some kind of
earnings multiples 128 percent claim to use some variation of discounted cash flow and
only seven of all reports use the price-earnings to growth ratio as their valuation method
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
22
Currently popular methods used by analysts include Discounted Cash Flow (DCF)
method Discounted Dividend Growth model and the Gordon Growth Model despite
which each has its own flaws and disadvantages The prevalent use of these methods has
been documented by Bradshaw (2002) Barker (1999) and Asquith et al (2005)
Analysts make forecasts on earning cash flows and growth rates and ultimately issue a
stock recommendation or a target price that reflects their opinions about the investment
value of the company Since the analysts primary role is to advise investors on whether a
stock is undervalued or overvalued recommendations should be related to their
valuations relative to current stock prices The predominant use of earnings forecasts in
valuing stocks as documented by Bradshaw (2002) and Asquith et al (2005) suggests that
analysts earnings forecasts valuations and stock recommendations are potentially flawed
The problem for this type of valuation is that it deals with the future The present value
of the cash flows and hence the stock price is a function of the analystrsquos expectations of
the future However the future is unknowable and therefore any value derived from
these models is pure estimation
Montgomery (2010) illustrates a further flaw in the Dividend Discount Model (DDM)
and its derivatives ldquoIf a company doesnrsquot pay all of its earnings out as a dividend there
are a potentially large amount of earnings that are retained and the DDM doesnrsquot
recognise this And if a company can generate high returns on those retained earnings
and can continue to retain and compound these earnings adjusting down its payout ratio
at the same time those retained earnings may be worth significantly more than the
dividends But the DDM doesnrsquot value these retained earningsrdquo
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
23
242 Market Approach The comparable sales approach focuses on sales of similar businesses in arms-length
transactions (Lokey amp Masson 1987) Data concerning sales of comparable companies
is often scarce nonetheless it is possible to examine the transactions in publicly traded
companies Given foreign banks ownership stakes and based on the price paid for
buyerrsquos stakes in Chinese banks it should be possible to establish the value foreign banks
assigned to each bank however this will not account for any special agreements5 that
may be involved
Hitchner (2003) outlines some of the advantages of this approach is it is simple to
understand and apply Also it uses actual data not estimates based on a number of
assumptions or judgments There are some drawbacks to this approach such as if there
are no similar companies or no recent transactions to compare to Some other
disadvantages of this approach include a lack of transparency in a transaction Most
important assumptions that were made in purchasing a comparable company are hidden
such as the buyerrsquos expectations of growth in sales or earnings It also lacks flexibility to
include unique operating characteristics of the firm in the price paid for that stake
243 Asset Approach The asset approach focuses on the assets of the business and the cost to replicate the
business or alternatively the amount to be received upon liquidation (Lokey amp Masson
1987) The assets of a company are typically comprised of 1) current assets (2) fixed
assets (3) personnel and (4) goodwill and other intangible assets (Nielsen amp Hudson
1987) While employees are not capitalized on the balance sheet they are often a firms
5 Such as strategic alliances or joint ventures in the credit card business and so forth
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
24
most important asset therefore employee evaluation is a major part of the quality factors
to be considered when evaluating a company
Neisen et al (1987) states that the asset approach determines value on a two-step basis
1 The value of the assets (current and fixed) other than cash goodwill and any
agreement not to compete and
2 The value of goodwill and any agreement not to compete6
The second step is more difficult to determine and given the subjective nature of
evaluating the value of goodwill and agreements the researcher will not include this
aspect in the study
25 The Worldrsquos Most Successful Investor In 1984 Warren Buffett gave a speech at the Columbia Business School challenging the
idea that equity markets are efficient He debated against Michael Jensen a proponent
for the ldquorandom walkrdquo and Efficient Market Hypothesis (EMH) Despite his argument
and presented evidence (Buffett 1984) nothing further was researched and it seems
Warren Buffettrsquos achievements as an investor have been dismissed as an ldquoaccidentrdquo or
ldquoflukerdquo in academia What is most striking is that Warren Buffett is inarguably one of if
not the most successful investors in the world and yet he remains rarely cited within
traditional academia
Dozens of books have been written over the years that analyze Warren Buffettrsquos
investment style While he is considered one of the most successful investors in the world
he has never detailed his exact method of valuing a company and determining whether it
6 An agreement not to compete is a common provision in a contract for sale of a business in which the seller agrees not to compete in the same business for a period of years or in the geographic area
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
25
has a sufficient margin of safety Few books have been able to figure out what Warren
Buffettrsquos real ldquosecret formulardquo of investing is
Warren Buffett is often quoted as saying he considers himself to be 85 Benjamin
Graham and 15 Philip Fisher In his paper The Superinvestors of Graham-and-
Doddsville Buffett (1984) states that Graham and Dodd investors hellip do not discuss beta
the capital asset pricing model or covariance in returns among securities They simply
focus on two variables price and valuerdquo
251 Fundamental Analysis According to Dodd (1988) in an era of acquisitions leveraged buyouts and restructurings
an intense analytical effort is required to determine the value of companies The Graham
and Dodd concept of security analysis with its emphasis on value is based on the
principles of fundamental analysis Graham et al (1988) describes fundamental analysis
as ldquoA method of evaluating a security that entails attempting to measure its intrinsic value
by examining related economic financial and other qualitative and quantitative factorsrdquo
252 Valueable While Warren Buffett has never revealed his formula for valuing a company his annual
chairmanrsquos letters contain great insight into his investment philosophy In Roger
Montgomeryrsquos book ldquoValueablerdquo Montgomery (2010) discusses two methods derived
from Buffettrsquos writings and presents two valuation tables (reproduced in Tables 21 and
22 contained in the appendix) Montgomery asserts that the basic arithmetic used in the
first table is consistent with a discussion of valuation that Buffet published in his 1981
Chairmanrsquos letter to Berkshire Hathaway shareholders applying to a company that pays
out all earnings as dividends The second table presented by Montgomery (2010) is
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
26
derived from the formula suggested by Richard Simmonsrsquo book ldquoBuffett step-by-step an
investorrsquos workbook ndash learn to analyze and apply the techniques of the master investorrdquo
which applies to a company that retains all earnings Montgomery (2010) states that
individually the formulae are incomplete Applied together however they provide a
practical approach to valuation
While this approach also has flaws such as need for stable economic data as the model
assumes a static return on equity the approach is simple to apply and will generate an
additional figure to the spectrum of values
26 Hypothesis Based on a review of the literature this study aims to expand the field of practical
valuation by applying a range of existing valuation methods in conjunction with the
newly proposed valuation of Montgomery (2010) These methods will be applied to the
Chinese banks chosen for this study that are listed in Chinarsquos developing securities
market
This study hypothesizes that the speculative nature of Chinarsquos security markets
contributes to the under and overvaluation of listed companies
H1 There is a large discrepancy between the listed market price and the intrinsic value of
Chinese banks
In other words state ownership negatively affects the intrinsic value of listed companies
H2 Non-state-owned banks will have an intrinsic value closer to their listed market price
when compared with state-owned banks
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
27
The following chapter details the methods that were applied for calculating the spectrum
of values and the Chinese banks to be tested in this research
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
28
III Research Methodology
31 Introduction The objective of this research is to examine valuation results of different approaches in
comparison to listed market prices of the selected Chinese banks in order to test the research
hypotheses The methodology adopted in this paper is eclectic An analysis of the
Chinese banks is a research area where quantitative data are difficult to interpret when
they are available at all Financial data are often incomplete or unclear and this paper
therefore is bound by realistic limits confining itself to a situation where the amount of
data is small yet its significance indefinite
Given Warren Buffettrsquos success as an investor Montgomeryrsquos adaptation derived from
Warren Buffetrsquos use of the Graham and Dodd approach shall be used for the purpose of
this study Therefore a careful consideration of the two approaches proposed by
Montgomery (2010) is required
The asset approach using data from the balance sheet and the market approach using
data gathered from foreign ownership purchases of Chinese banks are only useful as a
starting point and were used to establish a baseline for the value range The valuation
approach proposed by Montgomery (2010) will then be applied to expand the spectrum
of values for each bank This spectrum will then be compared with current market price
of each bank
I hope to produce from these disparate sources a synthesis that draws reliable conclusions
when possible and when not possible marks those areas that invite further research
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
29
32 Sampling and Data Collection A total of 8 banks listed on the Shanghai Stock Exchange were analyzed These banks
consist of the ldquoBig Fourrdquo state-owned banks Agricultural Bank of China Bank of China
China Construction Bank Industrial and Commercial Bank of China and four non-state-
owned banks Bank of Communications CITIC Bank China Merchants Bank and
Shanghai Pudong Development Bank
Firmsrsquo data on total assets liabilities earnings and other relevant financial data were
extracted and calculated from firmsrsquo annual reports for the year 2010 and for as many
years prior as available Due to some banks such as the Agricultural Bank of China only
publically listing in recent years various financial data is limited If annual reports or
financial data were unavailable attempts were made to source from appropriate financial
databases7
The prices of relevant stocks were extracted from the Shanghai Stock Exchange for the
target banks as of December 31st for each relevant financial year The reason for
establishing the stock price on December 31st is to establish an appropriate comparison of
the year end share price with the intrinsic value formulated from financial data as of
December 31st It is unlikely that all historical stock prices can be extracted Therefore
with these limitations the data is to be collected tested and analyzed according to the
approaches outlined in this chapter
7 For example Reuters Thompsons and Morningstar
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
30
33 Valuation Models 331 Estimating Target Bankrsquos Value Using the Asset Approach
In the asset approach the value of the target bank is estimated from subtracting all
liabilities from total assets to derive the value of the equity of the bank This determines
the approximate net worth of the company For the purpose of this study it is assumed
that accounting book value is an accurate representation of an assetrsquos value In order for
ease of comparison of price paid per share this final equity amount was divided by the
total shares to create an equity per share amount
332 Estimating Target Bankrsquos Value Using the Market approach The researcher examined foreign ownership stakes in each target bank and based on what
they were paid in each corporate acquisition established an estimate of the value foreign
strategic investors assigned to each bank Browne (2007) suggests that most of the time
such values are close to real worth at the time of the transaction
333 Estimating Target Bankrsquos Value Using the Montgomery Method Montgomery (2010) stresses that one of the most important factors in identifying the
value of a business is its ability to generate profits As such the Return on Equity (ROE)
ratio is selected as a measure of the earning power of a business This is because return
on equity is an indicator of profitability and an ldquoessential ingredient in establishing the
economic performance of the businessrdquo Return on equity is calculated by dividing the
net profit after tax (NPAT) of the company by the average of equity for the last year and
current equity It is important to note that debt can adversely affect this ratio These
figures were extracted from the banksrsquo balance sheets and statements of cash flow
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
31
Once the ROE has been established a required rate of return must also be established
For the purpose of this study the researcher will adopt an after-tax investorrsquos required
return of 10 as suggested for illustrative purposes by Montgomery (2010)
The researcher will then use these two figures in both Tables 21 and 22 to determine
the appropriate multiplier to apply to each banksrsquo equity per share This will give two
figures corresponding to two valuation scenarios 1) if the bank were to pay out 100 per
cent of their earnings as dividends 2) if the bank were to retain all earnings
Montgomery (2010) states that in the real world most businesses payout a significant
proportion of their earnings and thus fall between the two examples His proposed
solution is to do the following First multiply the result obtained from using Table 21
by the payout ratio8 Second multiply the result obtained from using Table 22 by one
minus the payout ratio The addition of the two results will arrive at an estimated
intrinsic value for the bank
34 Analysis The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st
341 Hypothesis Testing For each target bank the extracted market prices were compared to the value range The
objective is to determine if the listed market price undervalues overvalues or falls within
the range of values for each target bank If the target price falls outside the value range
then further analysis should be done to determine if a large discrepancy exists This is in
8 Calculated as Dividends per Share divided by Earnings per Share
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
32
line with the objectives of the research to determine if a large discrepancy exists between
intrinsic value and market price This was examined in light of the first hypothesis
The research will also evaluate the proximity of the non-state-owned banksrsquo intrinsic
value to their listed market price in comparison to that of the state-owned banks This is
in line with the research objective of comparing state-owned banks intrinsic value and
market price and that of the non-state-owned This was examined in light of the second
hypothesis
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
33
IV Results of the Comparison
41 Introduction This chapter presents the results of the research The first section discusses the
descriptive statistics of Asset Approach data collected in this research This is followed
by the descriptive statistics of the Market Approach data collected and the next section
presents the descriptive statistics of the data sample using the proposed Montgomery
Method
This chapter then discusses the comparisons of the market prices of the Chinese banks
with the results of each valuation method to determine which bankrsquos price lie within or
outside the value range The chapter ends with the results of the hypotheses being tested
and the summary of the findings
42 Descriptive Statistics Asset Approach This section describes the data collected for the Asset Approach The total number of
banks studied is eight The data is collected from companiesrsquo annual reports obtained
from the investor relations section of each banksrsquo websites The annual reports studied in
this research are for the financial data of the year 2010 and for as many years prior as
available
421 Non-State-Owned Banks
The following tables illustrate the total asset and liability data collected for the non-state-
owned banks
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
34
Table 421-1 Bank of Communications
Bank of Communication
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 3951593 3727936 223657 398
2009 3309137 3144712 164425 336
2008 2682947 2532852 150095 306
2007 2110444 1977123 133321 272
2006 1719483 1628988 90495 198
2005 1423439 1340293 83146 182
2004 1144005 1091902 52103 114
Table 421 illustrates the net worth of the Bank of Communications as increasing
annually As of December 31st 2010 the base value range of the Bank of
Communications is 398 RMB
Table 0-2 CITIC Bank
CITIC Bank Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 2081314 1956776 124538 319
2009 1776276 1668023 108253 277
2008 1319570 1190196 129374 331
2007 1011186 927095 84091 215
2006 706723 675029 31694 102
2005 594602 571377 23225 075
Table 422 illustrates the net worth of the CITIC Bank as increasing annually As of
December 31st 2010 the base value range of the CITIC Bank is 319 RMB
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
35
Table 0-3 China Merchants Bank
Merchants Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 2402507 2268501 134006 621
2009 2067941 1975158 92783 485
2008 1571797 1492016 79781 542
2007 1310964 1242568 68396 465
2006 934102 878942 55160 375
2005 734613 708615 25998 251
Table 423 illustrates the net worth of the China Merchants Bank as increasing annually
until 2008 where there was a decline As of December 31st 2010 the base value range
of the China Merchants Bank is 621RMB
Table 0-4 Shanghai Pudong Development Bank
Pudong Development
Bank
Total Assets
Total Liabilities Remaining Equity
Equity Per Share
2010 2191411 2068131 123280 859
2009 1622718 1554631 68087 771
2008 1309425 1267724 41702 737
2007 914980 886682 28298 650
2006 689358 664638 24720 625
2005 573523 557553 15969 408
2004 455532 442022 13510 345
2003 371057 359046 12011 307
2002 279301 271340 7960 220
2001 173691 166624 7067 293
2000 111591 109197 2394 099
1999 103210 95434 7776 323
1998 84926 81671 3255 162
1997 81496 67908 13589 676
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
36
Table 424 illustrates the net worth of the Shanghai Pudong Development Bank as
initially decreasing then a turnaround to increasing annually from 2001 As of December
31st 2010 the base value range of the Shanghai Pudong Development Bank is 859
422 State-Owned Banks Table 422-1 Agricultural Bank of China
Agricultural Bank of China
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10337406 9795170 542236 167
2009 8882588 8539663 342925 132
2008 7014351 6723810 290541 112
2007 5305506 6033111 ‐727605 ‐280
Table 425 illustrates the net worth of the Agricultural Bank of China as increasing
annually Prior to publicly listing the bank had a severe problem with Non Performing
Loans (NPLs) which lead to liabilities greater than the assets of the bank creating a
negative equity figure This was rectified prior to the IPO with the assistance of the
Chinese Government 9 As of December 31st 2010 the base value range of the
Agricultural Bank of China is 167RMB
Table 422-2 Bank of China
Bank of China Total Assets Total Liabilities Remaining Equity Equity Per Share
2010 10459865 9783715 676150 242
2009 8748177 8206549 541628 213
2008 6951680 6461793 489887 193
2007 5991217 5540560 450657 178
2006 5327653 4914697 412956 163
2005 4740048 4484529 255519 122
2004 4270443 4037705 232738 125
9 The Ministry of Finance of the Peoples Republic of China established four financial asset management corporations (AMCs) one for each of the four commercial state-owned banks to purchase Non-Performing Loans and thereby improve the banksrsquo balance sheets prior to publicly listing In the case of the Agricultural Bank of China the Great Wall AMC was created
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
37
Table 426 illustrates the net worth of the Bank of China as increasing annually As of
December 31st 2010 the base value range of the Bank of China is 242RMB
Table 422-3 China Construction Bank
Construction Bank
Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 10810317 10109412 700905 280
2009 9623355 9064335 559020 239
2008 7555452 7087890 467562 200
2007 6598177 6175896 422281 181
2006 5448511 5118307 330204 147
2005 4585742 4298065 287677 128
2004 3909920 3714369 195551 101
Table 427 illustrates the net worth of the China Construction Bank as increasing
annually As of December 31st 2010 the base value range of the China Construction
Bank is 280RMB
Table 422-4 Industrial and Commercial Bank of China
ICBC Total Assets Total Liabilities Remaining Equity
Equity Per Share
2010 13458622 12636965 821657 235
2009 11785053 11106119 678934 203
2008 9757146 9150516 606630 182
2007 8683712 8140036 543676 163
2006 7508751 7037750 471001 141
2005 6456131 6196255 259876 105
2004 5069324 5577369 (508045) ‐205
Table 428 illustrates the net worth of the Industrial and Commercial Bank of China as
increasing annually As with the Agricultural Bank of China prior to publicly listing
ICBC had a severe problem with Non Performing Loans (NPLs) which lead to liabilities
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
38
greater than the assets of the bank creating a negative equity figure This was rectified
prior to the IPO with the assistance of the Chinese Government10 As of December 31st
2010 the base value range of the Industrial and Commercial Bank of China is 235RMB
43 Descriptive Statistics Market Approach This section describes the initial and subsequent public offering issue prices of the
researched Chinese banks and the foreign ownership stakes each banks Where a
substantial ownership stake is found such as a strategic partnership or strategic
investment attempts have been made to discover the price paid at the time of transaction
As mentioned previously one of the disadvantages of this approach includes a lack of
transparency in a transaction Most of the important assumptions that strategic investors
made in purchasing and divestment of their holdings are hidden such as their
expectations of growth in sales or earnings It also lacks flexibility to include unique
operating characteristics of the firm in the value it produces Another potential flaw is
that many foreign ownership transactions occurred in the Hong Kong Stock Exchange
and not the Shanghai Stock Exchange so exchange rate conversions must be made which
may distort the value figure
431 Non-State-Owned
Bank of Communications
HSBC is the sole strategic investor in the Bank of Communications As of January 2005
HSBC purchased an ownership stake of 199 of the Bank of Communications HSBC
held 777 billion shares in the bank purchased for 186 RMB per share 149 times the
10 The Huarong AMC was created to handle assume the non-performing assets primarily NPLs of ICBC
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
39
companys stated 2004 book value and at a slight premium to the value of the equity per
share
In June 2010 HSBC agreed to subscribe to Bank of Communications new rights issue for
1396802037 H-rights shares at HK$514 per share ( approximately 448RMB per share)
The transaction represented a consideration of approximately HK$7180 million thereby
maintaining HSBCs 199 stake HSBC has yet to divest any shares
CITIC Bank
In 2007 Banco Bilbao Vizcaya Argentaria SA (BBVA) a Spanish based banking group
negotiated to be CITIC bankrsquos sole strategic investor and purchased 483 of CITIC
shares at 342RMB per share This was approximately a 40 discount to the IPO issue
price of 580RMB The IPO value range was set at HK$506-HK$586 while the range
for the Shanghai-listed shares was set between 500RMB to 580 RMB each The shares
were issued pursuant to the anti-dilution rights and top up rights
According to Reuters (Ku 2007) CITIC Bank was forced to lower its maximum issue
price to 275 times its 2007 book value from 281 times as mainland institutional
investors and regulators deemed the valuation too rich Since the bank has been listed in
the Hong Kong Stock Exchange it has performed the poorest among the all ldquoRed Chiprdquo11
financial stocks It dropped below the IPO price HK$580 and closed at HK$579 on 5
June 2007
11 A stock in a company operating in the Peoples Republic of China that trades on the Hong Kong Stock Exchange Generally speaking only Chinese citizens are allowed to invest on Chinese stock exchanges Red chips are therefore separately incorporated in Hong Kong in order to allow foreign investment in Chinese companies The term refers to the color red which is the official color of the Communist party
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
40
In 2009 BBVA increased its shareholding in the Bank on two consecutive occasions up
to 15 of total shares first up to 1007 on February 2009 and up to 1512 later with
the transaction closing on April 1st 2010 The option was executed at HKD 645 per
share13 a price comparable to that of the initial IPO price
China Merchants Bank
China Merchants Bank initial public offering was 15 billion common shares in RMB (A
Shares) at an issue price of 730RMB per share on Shanghai Stock Exchange on 27
March 2002 The Hong Kong IPO issued 22 billion overseas listed foreign currency
denominated shares (H shares) on 22 September 2006 at HK$855 per share14
There are two foreign ownership stakes in China Merchants Bank The largest is
JPMorgan Chase holding approximately 452 million shares The second is Blackrock
Inc holding 265 million shares However neither has holdings of over 5 of total shares
China Merchants Bank does not have a strategic investor relationship with either foreign
owners Both ownerships trade predominantly in the Hong Kong Exchange and appear to
have no invested commitment to the bank
In March 2010 (Jianxin amp Master 2010) China Merchants Bank set an A-share rights
issue price of 885 RMB per share compared with a closing price of 163 RMB of its A
shares listed on the Shanghai Stock Exchange at the time of announcement
12 By exercising its share option from a Share and Option Agreement entered into on 22 November 2006 13 Approximately 586RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0880675 CNY) 14 Approximately 842RMB per share based on September 2006 average exchange rate
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
41
Shanghai Pudong Development Bank
On September 23 1999 the Shanghai Pudong Development Bank (SPDB) issued
400000000 ordinary shares (Share A) to general public in China with issue price of
1000RMB for each share It has held several capital raisings since this initial IPO
On 23 December 2002 the Company issued additional A share 300 million shares with
an issue price of 845RMB for each share On November 16 2006 the bank issued
additional A share 700 million shares with an issue price of 1364RMB for each A
decade after going public on September 18 2009 the bank issued a further 904 million
non-publicly offered A shares with an issue price of 1659RMB per share
Table 431-1 Summary of SPDB New Shares Issue Prices
Year Price (RMB)
September 1999 1000
December 2002 845
November 2006 1364
September 2009 1659
Since 2003 Citibank Overseas Investment Co has held a stake of approximately 5 of
the total share capital of the bank Citibank originally invested 600 million yuan to buy
the five-percent stake in SPDB (approximately 332RMB per share) Every Apr 30 from
2006 to 2008 Citibank had the option to buy SPDB shares from Shanghai State Assets
Managing Co Ltd and Shanghais Jiushi Company and SPDB non-circulating shares
taking its stake in SPDB up to 249 percent However Citigroup has not raised its
ownership stake and in 2006 reduced it slightly to 378 In 2008 SPDB implemented a
profit distribution plan of 4 bonus shares for every 10 shares during the period and
Citibanks percentage holding was further reduced to 339
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
42
432 State-Owned
Agricultural Bank of China
In June 2010 Standard Chartered Bank invested US$500 million as a cornerstone
investor in Agricultural Bank of China Limitedrsquos H-Share Initial Public Offering (IPO) in
Hong Kong The two banks signed an agreement to develop new business opportunities
together The consideration was financed from Standard Charteredrsquos internal cash
resources and was for the number of shares with a total value at the offer price of the
Hong Kong dollars equivalent of US$500 million This holding is only 037 of the total
shares however due to the recent timing of the IPO it is unknown if Standard Chartered
has call options or other opportunities to increase its stake at a later date As Standard
Chartered paid the HKD offer price the equivalent 268 RMB offer price is considered
for the value range of the Agricultural Bank of China
Bank of China
In 2005 the Bank of China entered into separate agreements and established strategic
partnerships with the Royal Bank of Scotland Group and its wholly owned RBS banks
and controlled RBS China (together ldquoRBSrdquo) Asia Financial Holdings Pte Ltd15 (AFH)
UBS AG (UBS) and the Asian Development Bank (ADB)
According to the Bank of Chinas 2005 annual report by the end of 2005 RBS held
20942736236 shares accounting for 10 of the Banks total equities AFH held
10471368118 shares or 5 total equity UBS AG held 3377860684 shares or about
16129 equity and the ADB held 506679102 shares approximately 02419 of the
15 It should be noted that the parent company of AFH is Temasek Holdings an investment company wholly owned by the government of Singapore
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
43
Banks total equities The Bank issued ordinary shares to each strategic investor at
1RMB per share The listed IPO issue price was 308RMB per share
RBS contractual commitment to retain the 426 Bank of China (BoC) stake ended on
31 December 2008 On January 7th and 14th 2009 RBS divested by sale or transfer its
entire stake in Bank of China According the RBS 2009 Annual Report the 426
investment in Bank of China was sold for HKD 184 billion approximately HK$17116
per share
According to UBS 2008 Annual Report in December 2008 UBS disposed of its equity
stake in Bank of China through a placing of approximately 34 billion Bank of China
Limited H-shares to institutional investors for a cash consideration of approximately CHF
887 million (HKD 6519 million) The sale values each share at approximately 193HKD
or about 170RMB
China Construction Bank
According to China Construction Bankrsquos 2005 Annual Report the Bank entered into
strategic investment and cooperation agreements with Bank of America Corporation
(lsquolsquoBank of Americarsquorsquo) on 17 June 2005 and an investment agreement with Asia Financial
Holdings Pte Ltd (lsquolsquoAFHrsquorsquo) on 1 July 2005
According to Bank of Americarsquos 2005 Annual Report on June 17 2005 Bank of
America committed to purchase approximately nine percent of the stock of China
Construction Bank (CCB) for $30 billion The initial purchase of CCB shares for $25
billion in August 2005 and during CCBrsquos initial public offering in October 2005 made an
16 Approximately 155RMB per share
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
44
additional purchase of $500 million As the float on the Hong Kong stock exchange had
an issue price of HK$235 per share (approximately 225RMB per share) it is calculated
that initial purchase of CCB shares was between 084 and 086RMB per share17
According to CCBrsquos 2008 Annual Report on 25 September 2007 the Bank issued 9
billion A-shares in its domestic IPO at an issuance price of 645RMB
According to CCB and Bank of Americarsquos 2008 Annual Reports in 2008 in accordance
with the Share Purchase and Options Agreement signed by Huijin18 and Bank of America
Bank of America exercised its call options in July and November 2008 acquiring
6000000000 H-shares and 19580153370 H-shares of the Bank respectively from
Huijin purchasing 256 billion common shares for approximately $92 billion paying
approximately 297RMB per share In addition in January 2009 Bank of America sold
56 billion common shares of their initial investment in CCB for $28 billion for
approximately 414RMB per share Later in 2009 Bank of America sold 191 billion
common shares representing their entire initial investment in CCB for $101 billion
approximately 438RMB per share
The other significant foreign shareholder of CCB is Temasek who now holds its shares in
the investment vehicle Fullerton Financial a wholly owned subsidiary of Temasek
Holdings They have not altered their ownership stake since the initial IPO The details
of their purchase conditions are not publicly available
17 Allowing for fluctuations in exchange rates dating back to the dates of the IPO 18 State-owned holder of the majority of CCBrsquos ordinary shares
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
45
Industrial and Commercial Bank of China
On 27 January 2006 the Bank entered into share purchase agreements with three foreign
strategic investors namely Goldman Sachs Allianz and American Express Goldman
Sachs Allianz and American Express subscribed for 16476014155 shares
6432601015 shares and 1276122233 shares newly issued by the Bank on 28 April
2006 for a consideration of USD 25822 million EUR 8247 million and USD 200
million respectively (on the basis of an agreed exchange rate of USD1 to RMB 80304
and EUR 1 to RMB 98167) Each investor paid 126RMB per share
On 29 June 2006 SSF19 subscribed for 14324392623 shares newly issued by the Bank
for a consideration of approximately RMB 18 billion or 126RMB per share
On 27 October 2006 Industrial and Commercial Bank of China Limited was
concurrently listed in Shanghai and Hong Kong The offering prices for A-shares and H-
shares were RMB 312 and HKD 307 per share The offering prices for A-shares and H-
shares were essentially the same having taken currency conversion into account
According to the joint press release by Industrial and Commercial Bank of China (ICBC)
and Allianz Group (Allianz) issued on March 25 2009 Allianz sold 3216300507 ICBC
H shares representing the shares that have become free from lock up on April 28 2009
to a select group of investors through a private sale for a sale price of 386 HKD per
share20 Allianz continues to hold 3216300508 H shares in ICBC
On the same date at the end of their lock-up period American Express also sold almost
half of their ownership stake approximately 63806 million shares also at HK$ 386 a 19 The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nationrsquos aging population and to support economic development and social stability 20 Between 338 and 340RMB per share
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
46
share through private sales At the end of September 2010 Goldman Sachs sold 304
billion ICBC shares at HK$ 57421 each
According to the ICBCrsquos 2010 Annual Report in November 2010 the Bank implemented
a rights issue of A shares and H shares The rights issue was conducted on the basis of
045 rights shares for every 10 existing shares with the same basis adopted for the rights
issue of A-shares and H-shares The subscription prices were RMB 299 per A rights
share and HK$ 349 per H rights share which were the same after exchange rate
adjustment
The subscription price per A rights share of RMB 299 represented a discount of
approximately 369 to the closing price of RMB 474 per A share as quoted on
Shanghai Stock Exchange (SSE) on the price determination date (10 November 2010 the
date on which the subscription price for the rights issue was determined) while the
subscription price per H rights share of HK$ 349 represented a discount of
approximately 474 to the closing price of HK$663 per H share as quoted on SEHK on
the price determination date
44 Descriptive Statistics Montgomery Method The following section outlines the estimated Intrinsic Value (IV) calculated using the
Montgomery Method and is based on financial data as of December 31st gathered from
the banksrsquo annual reports The IV is then compared with the listed share price for each
bank as of December 31st for each year
21 Approximately 501RMB per share
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
47
441 Non-State-Owned For the purpose of comparison of non-state-owned banks with a long standing publicly
listed bank the estimated intrinsic values of HSBC22 have been included in the following
table This creates a reference benchmark of a non-Chinese bank
Table 441-1 Comparison of Non-State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC23 Bank of
Communication CITIC Bank Merchants
Shanghai Pudong
Development Bank
IV Share Price IV Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 1221
556
999
525
2449
1281
2904
1239
2009 384 1153 1002
935
383
823
1458
1805
3807
2169
2008 586 875 824
474
446
386
2980
1216
6776
1325
2007 2023 1689 649
1562
447
1015
2265
3963
2153
5280
2006 1744 1830 381
‐
152
‐
678
1636
1243
2131
2005 1819 1606 262
‐
111
‐
362
‐
1042
975
As shown in Table 441 the banksrsquo intrinsic values are generally rising over time and
share price is decreasing leading to a convergence between the two It should be noted
that the Chinese banks began with high share prices which fluctuated significantly In
2008 across the board all banks drastically increased net profits after tax (NPAT) This
created a spike in intrinsic value for some banks however these increases were not
sustained and hence intrinsic value dropped the following year One exception to this
appears to be the Bank of Communications which has maintained a stable and steadily
rising intrinsic value
22 HSBCrsquos financial data is reported in US dollars 23 As with most global banks it appears HSBCrsquos intrinsic value was impacted in the years of the GFC
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
48
442 State-Owned For the purpose of comparison of state-owned banks with a long standing publicly listed
bank the estimated intrinsic values of HSBC24 have been included in the following table
Table 442-1 Comparison of State-Owned Bankrsquos Montgomery Intrinsic Value
HSBC Agricultural Bank of China Bank of China
China Construction Bank ICBC
IV Share Price IV
Share Price IV
Share Price IV
Share Price IV
Share Price
2010 587 1025 498
268 543
323
826
459 846
424
2009 384 1153 399
270 367
433
768
619 575
544
2008 586 875 032 ‐ 326
297
566
383 521
354
2007 2023 1689 ‐ 080 ‐ 301
661
359
985 411
813
2006 1744 1830 ‐ ‐ 292
543
293 254
620
2005 1819 1606 ‐ ‐ 147
189
‐ 154
‐
As shown in Table 442 the intrinsic value of the state-owned banks has risen every year
and appears to be far more stable than that of the non-state-owned banks As with the
non-state-owned banks upon listing with the exception of the Agricultural Bank of
China each bank had a share price well above that of the estimated intrinsic value Over
time the share price has moved to converge with estimated intrinsic value
45 Market Price Comparison with Value Range The results from each approach were combined to establish a spectrum of values for each
target bank This value range was then compared to the yearly market price of the listed
banks as of December 31st to determine if the market price falls within or outside the
estimated value range
24 HSBCrsquos financial data is reported in US dollars
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
49
451 Non-State-Owned Table 451-1 Bank of Communications
Bank of Communications
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 398 448 1221 556 601
2009 336 1002 935 1070
2008 306 824 474 787
2007 272 649 1562 1183
2006 198 381
2005 ‐ Jan Pre‐IPO 182 186 262
2004 114 114
The Bank of Communications share price falls within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-2 CITIC Bank
CITIC Bank Asset Market Montgomery IV
Dec 31st Share Price
2010 319 999 525
2009 277 586 383 823
2008 331 446 386
2007 215 342 447 1015
2006 102 152
2005 075 111
The CITIC Bank share price falls within the established value range As of December
31st 2010 the share price appears to be at a discount to its estimated intrinsic value
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
50
Table 451-3 China Merchants Bank
China Merchants Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 621 2449 1281
2009 485 1458 1805
2008 542 2980 1216
2007 465 2265 3963
2006 375 678 1636
2005 251 362
The China Merchants Bank share price has fluctuated greatly Some years the share price
is outside the valuation range other years within the established value range As of
December 31st 2010 the share price appears to be at a discount to its estimated intrinsic
value
Table 451-4 Shanghai Pudong Development Bank
Shanghai Pudong Development Bank
Asset Market Montgomery IV
Dec 31st Share Price
2010 859 2904 1239
2009 771 3807 2169
2008 737 6776 1325
2007 650 2153 5280
2006 625 1243 2131
2005 408 1042 975
2004 345 672 700
2003 307 332 592 1053
2002 220 231 986
2001 293 293 1569
2000 099 276 2075
1999 323 ‐879 2475
1998 162 560 000
1997 676 146 000
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
51
As with the China Merchants Bank the Shanghai Pudong Development Bank share price
has fluctuated greatly Initially the share price lay outside the value range and over time
decreased to converge with intrinsic value However in the volatile years surrounding the
GFC the share price jumped and then it appears that intrinsic value has risen rapidly till
the share price now falls with the value range As of December 31st 2010 the share price
appears to be at a discount to its estimated intrinsic value
452 State-Owned Table 452-1 Agricultural Bank of China
Agricultural Bank of China
Asset Market Montgomery IV
Dec 31st Share Price
2010 167 268 498 268
2009 132 399
2008 112 032
2007 ‐280 ‐080
As the Agricultural Bank of China listed recently there is no longitudinal data for
comparison Initially the share price lay within the value range As of December 31st
2010 the share price appears to be at a discount to its estimated intrinsic value
Table 452-2 Bank of China
Bank of China Asset Market Montgomery IV
Dec 31st Share Price
2010 242 543 323
2009 213 155 367 433
2008 193 170 326 297
2007 178 301 661
2006 163 308 292 543
2005 122 100 147
2004 125 000
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
52
The Bank of China share price has fluctuated less than that of the non-state-owned banks
Initially the share price lay outside the valuation range however over time gradually
converging to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
Table 452-3 China Construction Bank
China Construction Bank
Asset Market Montgomery IV
Dec 31st Share Price
6 Month Average Share
Price
2010 280 826 459 485
2009 sale 239 438 768 619 647
January 2009 sale 414
2008 purchase 200 297 566 383 577
2007 181 359 985
2006 147 293
2005 128 225 189
June 2005 ‐ Pre IPO 084 ~086RMB
The China Construction Bank share price was initially greater than the estimated intrinsic
value range As with other banks it appears the share price gradually converges to within
the established value range As of December 31st 2010 the share price appears to be at a
discount to its estimated intrinsic value
Table 452-4 Industrial and Commercial Bank of China
ICBC Asset Market Montgomery IV
Dec 31st Share Price
2010 235 846 424
Sept 2010 sale 501
2009 203 575 544
March 2009 sale 338 ~ 340
2008 182 521 354
2007 163 411 813
2006 141 312 254 62
2006 ‐ Pre IPO 126
2005 105 154
2004 ‐205 000
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
53
The Industrial and Commercial Bank of China share price was initially greater than the
estimated intrinsic value range As with other banks it appears the share price gradually
converges to within the established value range As of December 31st 2010 the share
price appears to be at a discount to its estimated intrinsic value
46 Macro Economic Factors It is important to consider the macro-economic factors that may have influenced the
results of this study Economic performance of the Chinese banks may have been
impacted in several ways by the global financial crisis Several of the Chinese banks
strategic investors were also impacted in particular the Royal Bank of Scotland and
Citibank
Bank of Communications appears to be the most stable of the non-state-owned banks and
their strategic investor HSBC has maintained its ownership stake without divesting any
shares However it is surprising that BBVA has increased their stake in CITIC Bank
threefold the reasons for this are unknown The researcher posits that due to BBVArsquos
strategic aim to grow business within the Asian market and CITIC Bankrsquos strategic aim
to grow their business in South America BBVA has a long term vision of cooperation
with CITIC Bank However this cannot be known for certain Citibank was seriously
affected by the global financial crisis and so it is not surprising that they did not take
advantage of their option to raise their stake in Shanghai Pudong Development Bank to
249 and their ownership stake has been diluted by capital raisings
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
54
While Standard Chartered has become a cornerstone investor in the Agricultural Bank of
China its ownership stake is conspicuously small at 037 this may illustrate a lack of
commitment to the holding It remains to be seen whether the bankrsquos relationship will
grow and develop into something more than a cornerstone investor On the world scale
UBS and RBS suffered severe financial losses during the GFC and in 2009 sold their
complete stake in Bank of China in order to bolster their balance sheets It is unknown if
they would have maintained their ownership stakes without the consequences of the crisis
on their financial standings
Similarly Allianz American Express and Goldman Sachs all chose to take profits and
reduce their stake holdings in ICBC however they still retain approximately half their
previous holdings Bank of America seems to have profited the most as they took
advantage of their call options to double their ownership stake in November of 2008 and
then a few months later in January 2009 they sold their original stake at nearly four times
the initial price paid
47 Results of Hypothesis Testing Based on the results the hypotheses stated for the research are tested The first hypothesis
proposes that the speculative nature of Chinarsquos security markets contributes to the under
and overvaluation of listed companies The second hypothesis proposes that the state
ownership negatively affects the intrinsic value of listed companies
H1 states that there is a large discrepancy between the listed market price and the intrinsic
value of Chinese banks The results earlier indicate support of H1 for non-state-owned
banks as shown in Figure 46-1 The volatility of the share price creates a large
discrepancy between listed market price and estimated intrinsic values The state-owned
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
55
banks intrinsic values and listed market prices appear to be more stable and as such the
results indicate the discrepancy between the two is not large as shown in Figure 46-2
Therefore for non-state-owned banks H1 is supported
H2 states that non-state-owned banks will have an intrinsic value closer their listed
market price when compared with state-owned banks The results earlier indicate that the
non-state-owned banks share price is far more volatile than that of the state-owned banks
The results suggest that the estimated intrinsic value of the state-owned banks has grown
more stably and is closer to their listed market price compared with non-state-owned
banks As such the results do not appear to support this hypothesis Possible
explanations of these results will be discussed in the concluding chapter
Figure 47-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks
‐
1000
2000
3000
4000
5000
6000
7000
8000
‐
1000
2000
3000
4000
5000
6000
2005 2006 2007 2008 2009 2010
Estimated Intrinsic Value
Maket Share Price
Merchants IV Bank of Communication IV
CITIC Bank IV Pudong IV
Bank of Communication Share Price CITIC Bank Share Price
Merchants Share Price Pudong Share Price
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
56
Figure 47-2 Comparative discrepancy between market price and intrinsic value of state-owned banks
48 Summary of Findings Based on the exploratory results compiled the important findings are summarized in this
section
The fluctuations in performance indicated by the results suggests that non-state-owned
banks appear to compete in a separate highly competitive market to that of the big four
state-owned banks This is in line with the finding of Garcia-Herrero et al (2006) that
suggests direct competition among the largest banks is weak due to several factors First
the price and quantity controls imposed by the government have not been fully lifted and
the opening up to foreign competition has proceeded cautiously Foreign competition is
limited to the wholesale business and in few areas Second Chinarsquos fast economic growth
and in particular the high investment rate implies that there is an enormous amount of
projects which need to be financed Thus there is room for all the banks to make business
‐
200
400
600
800
1000
1200
‐
100
200
300
400
500
600
700
800
900
2005 2006 2007 2008 2009 2010
Estimated In
trinsic Value
Market Share Price
Agricultural Bank of China IV Bank of China IV
China Construction Bank IV ICBC IV
Agricultural Bank of China Share Price Bank of China Share Price
ICBC Share Price China Construction Bank Share Price
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
57
Finally the excessive liquidity of the banking system inhibits competition so even the
programmed full liberalization of the deposit rate might not increase competition in this
setting (Garcia-Herrero et al 2006)
The fluctuation of non-state-owned banks supports the view that the speculative nature of
the Chinese securities markets contributes to the under and over valuation of its listed
companies
The research results indicate that the market price is frequently out of line with the
estimate intrinsic value and second that there seems to be an inherent tendency for these
disparities to correct themselves It can be assumed that throughout these periods
investors fall prey to their emotions and as a group may decrease a stock price below
intrinsic value during market pessimism Conversely stock prices appear to increase to
levels above intrinsic value upon market optimism Non-state-owned banks seem to
fluctuate so much that it is uncertain whether any convergence would be statistically
significant State-owned convergence is more likely to be significant
Graham (2003) and Montgomery (2010) assert that in the short run stock markets are in
essence a voting machine whereon countless individuals register choices which are the
product partly of reason and partly of emotion with voting requiring only money not
intelligence or emotional stability However they also stress that in the long term the
market is a weighing machine and therefore share price performance eventually reflects
the economic performance of the underlying business whereby over time price will
reflect the direction of intrinsic value
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
58
V Research Findings and Conclusions
51 Introduction This section discusses the research findings on valuation range estimated through the use
of the Asset Approach Market Approach and the Montgomery Method This is followed
by discussion of the implication and the limitations of the research Recommendations for
future research are presented and finally this is followed by the conclusion of the paper
52 Considerable Differences Among Various Evaluations The objective of the study is to examine whether the developing securities markets of
China undervalue or overvalue member banks by measuring indicators of profitability
and growth such as Return on Equity illustrating how efficiently bank management
allocates capital and thereby allowing an estimate of their intrinsic values in comparison
to their listed market prices
In studying the financial data from each bankrsquos annual reports the research evaluated the
companies according to three methods a calculated equity per share a spot price paid for
shares by foreign investors and an estimated intrinsic value For each method the
research further conducted a comparison between the valuation range and year-end
market share price
The new valuation method proposed by Roger Montgomery and used by this research
indicates a different value investing philosophy with a value estimate significantly
different from other valuation methods results indicated within the table series 451 and
452 Therefore the research sheds more light on the comparable value of the Chinese
banks and shows a more complete picture of these banks in depth
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
59
It is suggested that one reason for the stability of the state-owned banks in comparison
with the non-state-owned banks is the capital inflows from the PRC government The
economic performance of all four state-owned banks was significantly improved due to
the creation of four asset managing companies to purchase non-performing assets and
remove them from the banksrsquo balance sheets
53 Research Implications The results of this research support partially the first hypothesis put forward in chapter II
which indicates that there is a large discrepancy between Chinese banks intrinsic values
and their listed share prices However the research does not support the second
hypothesis that non-state-owned banks will have an intrinsic value closer to their listed
market price when compared with state-owned banks was not upheld
This research contributes to the understanding of Chinese banks as a hot area of emerging
economies and transitory economies As indicated by the comparative case of HSBC this
research also makes its contribution to the evaluation of bank performance in a developed
economy
54 Limitations of the Research While focusing on the developing securities markets of China most foreign ownership
transactions occurred in the Hong Kong Stock Exchange It is suggested for future
research to study the robustness of the valuation methods against a larger sample of the
Chinese banks This research only applies the valuation methods to the banks with a
limited time series data Therefore the results may not be significant enough to indicate
any strong trend for these banks This may explain some of the volatile statistics that
were found by the research Larger sample sizes and longer time periods may lead to a
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
60
more concrete conclusion of whether the valuation ranges are optimal in estimating
intrinsic value It is recommended that future research test the results against a larger
group of comparable companies
In order for a fair estimate of intrinsic value the Montgomery Method requires a strong
competitive advantage of the targeted company in order to maintain stable returns on
equity and little or no debt as high levels of borrowing can make return on equity look
artificially good Due to their size and established brand it seems the four Chinese state-
owned banks have a strong competitive advantage over the non-state-owned banks The
most valuable competitive advantages are those that allow a company to raise service
fees or charges each year Montgomery (2010) states ldquoa continuous emotional attachment
to the brandproduct or servicerdquo provides that ability Given the government regulation
controlling the banking sector it is worth noting that the inability of banks (state and non-
state owned) to adjusted their fees independently may have long term effects on their
profitability
This research has focused primarily on quantitative factors effecting intrinsic value
However it does not take into account issues such as convertible bonds and the debt
levels of the banks Other qualitative factors of value such as brand names corporate
governance management and so forth have not been evaluated in terms of their affect on
intrinsic value
55 Recommendations for Future Research This study utilizes the data available in annual reports in its valuation method However
aggregated analystsrsquo predicted future earnings of listed companies could potentially be
used to estimate future intrinsic values Therefore it is suggested to study the effects of
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
61
estimated future intrinsic value in a longitudinal study Montgomery( 2010) posits that
over the long term prices converge with intrinsic value So a longitudinal study over an
extended period could test the correlation between estimated intrinsic value and market
share price This has the potential to become an important parameter of corporate growth
As this research only studies the banks listed in China specifically the Shanghai Stock
Exchange it is suggested for future works to examine whether the results still hold when
conducted in other countries And in the case of China a comparison between Shanghai
and Hong Kong exchanges could be examined for example an analysis of the price
value differences of dual listed companies between the Hong Kong Stock Exchange and
Shanghai Stock Exchange
The Montgomery Method can be enhanced by the addition of qualitative factors and
measuring the influence of them on intrinsic value Finally a study of applying different
levels of the required return to generate a valuation range and a margin of safety as
described by Graham et al (1988) and Montgomery (2010)
56 Conclusions The timing of the research is significant as ten years prior the Chinese banks had
numerous performance problems such as NPLs which drastically reduced their value
Five years prior there was limited financial data available for estimating the value of the
Chinese banks This research was lucky in its timing as the banks have been through a
transitionary aspect of the economy and have begun adapting to the nature of a market
economy
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
62
As various valuation methods are practiced by financial analysts in valuing companies
this study contributes an additional method the Montgomery Method The research also
hopes to encourage more studies in Graham-style valuing of firms and utilizing the best
methods in valuing companies
Value can change due to various factors such as political economic societal and
technological factors including the valuation methods used Just because a companyrsquos
share price is lower than the estimated valuation does not mean the price will go up
Conversely a price that is well above the estimated valuation doesnrsquot mean the share
price is going to fall The idea is not to be perfect but to protect capital and do better than
the market Investment behavior should not be price-driven but value-driven
Therefore it can be concluded that the combined valuation methods and valuation range
used in this research provide a much better reference base to compare with price This
comparison can then be used to base an investment decision to buy sell or hold It is thus
hoped that a more effective methodology is then derived for industry practice in the
future
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
63
References and Bibliography
Agricultural Bank of China (2004-2010) Annual Reports Retrieved from
httpwwwabchinacomenabout-usannual-report
Allen F Qian J Zhang C amp Zhao M (2010) Chinas Financial System
Opportunities and Challenges Capitalizing China Conference Boston Boston College
American Institute of Certified Public Accountants (2001) International Glossary of
Business and Valuation Terms Business Valuation Resources LLC
Asprem M (1989 September) Stock Prices Asset Portfolios and Macroeconomic
Variables in Ten European Countries Journal of Banking amp Finance
Asquith P Mikhail M B amp S A (2004 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Asquith P Mikhail M B amp S A (2005 February 15) Information Content of Equity
Analyst Reports Journal of Financial Economics
Bank of China (2005-2010) Annual Reports Retrieved from
httpwwwboccneninvestorir3
Bank of Communications (2005-2010) Annual Reports Retrieved from
httpwwwbankcommcomBankCommSiteeninvest_relationcompany_developjspty
pe=report
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
64
Barker R (1999) Survey and market-based evidence of industry-dependence in
analysts preferences between the dividend yield and price-earnings ratio valuation
models Journal of Business Finance and Accounting
Barker R (1999) The role of dividends in valuation models used by analysts and fund
managers European Accounting Review
Berger A N Hasan I amp Zhou M (2008) Bank Ownership and Efficiency in China
What will Happen in the Worlds Largest Nation Journal of Banking amp Finance
Berk J amp DeMarzo P (2007) Corporate Finance Boston Pearson Education Inc
Bradshaw M T (2002 March) The Use of Target Prices to Justify Sell-Side Analysts
Stock Recommendations Accounting Horizons
Brandt L amp Rawski T G (2008) Chinarsquos Great Economic Transformation
Cambridge University Press
Browne C (2007) The Little Book of Value Investing Hoboken John Wileyamp SonsInc
Buffett W (1976 November December) Benjamin Graham Financial Analyst
Journal
Buffett W (1977 - 2009) Chairmans Letter Berkshire Hathaway
Buffett W (1984) The Superinvestors of Graham-and-Doddsville Hermes the
Columbia Business School Magazine
Bulmash S B amp Trivoli G W (Summer 1991) Time-Lagged Interactions Between
Stock Prices and Selected Economic Variables Journal of Portfolio Management
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
65
Chen N-F Roll R amp Ross S A (1986 July) Economic Forces and the Stock Market
The Journal of Business
Cheung Y-W amp Ng L K (1998) International evidence on the stock market and
aggregate economic activity Journal of Empirical Finance
China CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
China Construction Bank (2004-2010) Annual Reports Retrieved from
httpwwwccbcomeninvestorannalshtml
China Merchants Bank (2006 - 2010) Annual Reports Retrieved from
httpenglishcmbchinacomcmbirenintroaspxtype=report
CITIC Bank (2007-2010) Annual Reports Retrieved from
httpbankeciticcominvestorrelationenglishfinancehtml
Damodaran A (1994) Damodaran on Valuation Security Analysis for Investment and
Corporate Finance Wiley amp Sons
Damodaran A (2005 June 14) Valuation Approaches and Metrics A Survey of the
Theory and Evidence Foundations and Trends in Finance
Economist (2010 February 4) Chinas Financial System Red Mist The Economist
Ezrati M (2010) Can China Become the Worlds Engine for Growth The International
Economy
Fama E F (1990) Stock prices expected returns and real activity Journal of Finance
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
66
Fama E F (1981) Stock prices real activity inflation and money American Economic
Review
Fama E F amp French K R (1989) Business conditions and expected returns on stocks
and bonds Journal of Financial Economics
Fama E F amp French K R (2007) The Anatomy of Value and Growth Stock Returns
Financial Analysts Journal
Garciacutea-Herrero A Gavilaacute S amp Santabaacuterbara D (2006 June) Chinas Banking Reform
An Assessment of its Evolution and Possible Impact CESifo Economic Studies
Graham B (2003) The Intelligent Investor - 4th Revised Edition New York Harper
Collins
Graham B Dodd D L Cottle S Murray R F amp Block F E (1988) Security
Analysis (5th Edition ed) New York McGraw-Hill
Hamlin K amp Yanping L (2010 August 16) China overtakes Japan as Worlds second-
biggest economy Bloomberg News
Healy P M amp Palepu K G (2003) The Fall of Enron Journal of Economic
Perspectives (Spring )
Hitchner J R (2003) Financial Valuation Applications and Models Hoboken New
Jersey John Wiley amp Sons Inc
Ho C-T amp Wu Y-S (2006) Benchmarking performance indicators for banks
Benchmarking An International Journal
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
67
Industrial and Commercial Bank of China (1998-2010) Annual Reports Retrieved from
httpwwwicbc-
ltdcomicbcltdinvestor20relationsfinancial20informationfinancial20reports
Jianxin L amp Master F (2010 March 1) China Merchants Bank launches $32 bln
rights issue Reuters
Kang J Liu M-H amp Ni S X (2002) Contrarian and momentum strategies in the
China stock Pacific Basin Finance Journal
King A M (2010 January February) Valuation Reports - Precision versus
Uncertainties Valuation Strategies
Ku D (2007 April 20th) Reuters Retrieved March 9th 2011 from
httpwwwreuterscomarticle20070420idUSHKG4451120070420
Liu M-H amp Shrestha K M (2008) Analysis of the long-term relationship between
macro-economic variables and the Chinese stock market using heteroscedastic
cointegration Managerial Finance
Lokey O K amp Masson R (1987 July) Evaluating the Closely Held Business
Management Review
Mandelker G amp Tandon K (1985 Jun) Common stock returns real activity money
and inflation Some international evidence Journal of International Money and Finance
McGuigan J R Moyer R C amp Harris F H (2007) Managerial Economics
Applications Strategies and Tactics Stamford Connecticut Cengage Learning
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
68
Montgomery R (2010) Valueable how to value the best stocks and buy them for less
than theyre worth (1st Edition ed) Melbourne My 2 Cents Worth Publishing
Mukherjee T K amp Naka A (1995) Dynamic relations between macroeconomic
variables and the Japanese stock market an application of a vector error correction model
Journal of Financial Research
Nielsen G L amp Hudson D H (1987 February) How to Value an Accounting Practice
The National Public Accountant
Pratt S Reilly R amp Schweihs R (2000) Valuing a Business (4 ed Ed) McGraw
Hill
Sargent M A (2008) Greed 101 Commonweal
Schwert G W (1990) Stock returns and real activity a century of evidence Journal of
Finance
Shanghai Pudong Development Bank (1999-2010) Annual Reports Retrieved from
httpwwwspdbcomcnchpagec531doclistaspx
Thavikulwat P (2004) Determining the value of a firm Developments in Business
Simulation and Experiential Learning
Wang F amp Xu Y (2004 November December) What Determines Chinese Stock
Returns Financial Analysts Journal
Wei L amp Corkery M (2008 September 17th) After Lehman Banks Jettison
Commercial-Property Debt The Wall Street Journal
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
69
Wen L (2008) The Accounting and Financial Performance of Non-State-Owned
Chinese Commercial Banks Journal of Performance Management
Westort P Kashian R amp Cummings R (2010) Does ownership form in community
banking impact profitability Managerial Finance
Wong S M (2006) Chinas Stock Market A Marriage of Capitalism and Socialism
Cato Journal
Wu H-L amp Chen C-H (2010 Fall) Operational Performance of Commercial Banks
in the Chinese Transitional Economy Journal of Developing Areas
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
70
Appendix
Table 21 Multiplier Selection when a Company Pays Out 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0625 0556 0500 0455 0417 0385 0357
725 0938 0833 0750 0682 0625 0577 0536
1000 1250 1111 1000 0909 0833 0769 0714
1250 1563 1389 1250 1136 1042 0962 0893
1500 1875 1667 1500 1364 1250 1154 1071
1725 2188 1944 1750 1591 1458 1346 1250
2000 2500 2222 2000 1818 1666 1538 1429
2250 2813 2500 2250 2045 1875 1730 1607
2500 3125 2777 2500 2272 2083 1923 1786
2750 3438 3055 2750 2500 2291 2115 1964
3000 3750 3333 3000 2727 2499 2307 2143
3250 4063 3610 3250 2954 2708 2499 2322
3500 4375 3888 3500 3181 2916 2692 2500
3750 4688 4166 3750 3408 3124 2884 2679
4000 5000 4444 4000 3636 3332 3076 2857
4250 5131 4721 4250 3863 3541 3268 3036
4500 5625 4999 4500 4090 3749 3460 3214
4750 5938 5277 4750 4317 3957 3653 3393
5000 6250 5554 5000 4544 4165 3845 3572
5250 6563 5832 5250 4772 4374 4037 3750
5500 6875 6110 5500 4999 4582 4229 3929
5750 7188 6387 5750 5226 4790 4421 4107
6000 7500 6665 6000 5453 4999 4614 4286
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729
71
Table 22 Multiplier Selection when a Company Retains 100 percent of its Earnings
Companys Return on Equity
Investors Required Rate of Return After‐Tax
8 9 10 11 12 13 14
500 0429 0347 0287 0242 0207 0179 0157
725 0890 0720 0596 0502 0429 0372 0325
1000 1494 1209 1000 0842 0720 0624 0546
1250 2233 1806 1494 1259 1076 0932 0815
1500 3100 2508 2075 1748 1494 1294 1132
1725 4092 3310 2738 2307 1972 1708 1494
2000 5203 4209 3482 2933 2508 2171 1900
2250 6432 5203 4305 3626 3100 2684 2349
2500 7776 6290 5203 4383 3748 3245 2840
2750 9231 7467 6177 5203 4449 3852 3371
3000 10796 8733 7225 6086 5203 4505 3943
3250 12469 10087 8344 7029 6010 5203 4554
3500 14248 11526 9535 8032 6867 5946 5203
3750 16132 13050 10796 9094 7776 6732 5891
4000 18119 14658 12126 10214 8733 7562 6617
4250 20209 16348 13524 11392 9740 8433 7800
4500 22399 18119 14989 12626 10796 9347 8180
4750 24688 19972 16521 13917 11899 10303 9016
5000 27076 21903 18119 15263 13050 11299 9888
5250 29561 23914 19783 16664 14248 12336 10796
5500 32143 26003 21511 18119 15493 13414 11739
5750 34821 28169 23302 19629 16783 14531 12717
6000 37593 30411 25158 21192 18119 15688 13729