Should Power Finance’s mcap be higher?

Note that there is no significant difference in the latest financial performance of these companies. In FY24, PFC and REC reported a standalone net profit of ₹14,367 crore and ₹14,019 crore, respectively. The loan book of the former was ₹4.8 trillion, while that of the latter was ₹5.1 trillion at FY24 end.

Currently, REC trades at a price-to-earnings multiple of about 10 times based on FY24 standalone earnings, which indicates a payback period of 10 years.

Now, both companies are assumed to have the same growth trajectory in future. Thus, using the sum-of-the-parts valuation methodology, if PFC also trades in line with REC’s price-to-earnings multiple, then the former should command about 25% premium on its current mcap.

To explain this: PFC’s net profit for FY24 stood at ₹14,367 crore, and at 10 times price-to earnings multiple, its mcap works out to ₹1,43,670 crore. Adding this to the 52% mcap of REC, PFC’s potential mcap works out to ₹2.3 trillion as against the current figure of ₹1.85 trillion. Both companies have subsidiaries, so standalone valuation is considered for the sake of simplicity.

Holding company discount

But skeptics could argue that a holding company discount would be applicable for valuing the stake in REC. However, that argument has little merit in this case for a couple of reasons. One, both the companies have almost identical business operations. Secondly, a holding company discount is generally applicable in cases where the parent company is either acting as mere holding company without any business activity and/or there is a difference between the businesses of the parent and subsidiary companies, for example, oil refining and telecom/retail in the case of Reliance Industries Ltd.

So, what is the rationale behind having different power financiers with the same ultimate owner, the government? Considering that PFC and REC are doing all kinds of power projects financing and the former has 52% stake in the latter, some may think it makes sense to merge the two companies.

However, the key obstacle for a merger is the borrowing limit from banks. According to the RBI’s guidelines issued in September 2019, a bank can lend only 20% of its net worth to an NBFC not giving gold loans. For instance, a bank with a net worth of ₹100 crore can lend ₹20 crore each to PFC and REC if they are separate companies, but this amount drops to ₹20 crore if the entities are merged. Lower lending of funds to power financing companies, in turn, reduces the onward lending by these companies.

Irrespective of a merger, the fact remains that both companies have healthy financials on a standalone basis. The key performance indicators such as RoE (return on equity) of about 20% for FY24 with net NPA of less than a percent and average interest spread of 2.7% have been acknowledged by analysts and investors alike.

This has enabled the course correction of the severe undervaluation of both PFC and REC as the stocks have tripled over the last one year. Their valuation, now at a price-to-adjusted-book-value of 2.25x-2.5x based on FY24, compares well with most banks and NBFCs with a few exceptions, such as Bajaj Finance.