We’re raising our valuation for IDFC Limited by 28% to Rs 198 per share, as we reduce our cost of equity, or discount rate, to 12% from 14%. Our new, higher fair value represents 2.2 times 2016 book value per share, and 12.7 times our fiscal 2016 earnings per share estimate.
The lower cost of equity assumption is in line with a global change to Morningstar’s cost of capital methodology, as it takes into account a lower required investment return for the U.S. market of 9%, plus a 3% country risk premium for Indian companies with average systematic risk. Our high fair value uncertainty rating remains unchanged: IDFC’s transition to a bank from being an NBFC will take a while to reflect more beneficially in its profits and returns. We also retain its no-moat rating, as IDFC has yet to build its cost advantages through scale of operations and a low-cost deposit franchise. Both are essential advantages its banking peers enjoy.
Our financial forecasts and outlook remain as before. We await further clarity on the exact strategy the firm will adopt to gather deposits. Whether this will be technology-led or branch banking-focused will determine where the cost-to-income will end up five years from now. Our five-year average earnings forecast remains at 14%, supported by strong, 15% average annual fee-income growth and 14% average annual interest income growth, derived from 13% average annual loan growth over our explicit five-year forecast.
From a longer-term perspective, we expect the firm to gather Rs 100 billion in deposits and reach a 25% cost-to-income ratio by fiscal 2019, compared to 15% as of nine-months ending December 2014. While the shares trade at a significant discount to our revised intrinsic value estimate, we caution investors that this long-term story will take time to play out. They should invest with an adequate margin of safety in mind.
