Are MFIs in India Overvalued?

This is one of those one million dollar questions present at many microfinance forums. A CGAP and JPMorgan report on equity valuation in microfinance in the context of the financial crisis is shedding new light on this debate. Based on our admittedly limited dataset of 21 private equity transactions, MFIs in India are trading at 5.9 their historical book value or close to 3 times the world average. So, are MFIs in India overvalued?

For sure, with 600 million people living below USD 1.5 a day, India has enormous potential for microfinance and as many observers keep repeating, penetration at the national level is still low and uneven. Moreover, the milestones of the sector are truly impressive: according to MIX, from 2003 to 2008, Indian MFIs have enjoyed the world’s highest growth rate in both assets and net income (over 100% per year on each metric over the last five years). They have maintained excellent asset quality (2008 median PAR30 at 0.36%) and a low-cost model, with a median efficiency ratio of only 11% compared to 19.8% for NBFCs globally.

Despite these impressive statistics, current valuation levels are a cause for concern. Just few thoughts steaming from the report to stimulate a debate:

First, the earning prospects of Indian MFIs do not justify such high level of valuations.
Current profitability is moderate. Microfinance NBFCs in India are only generating a median ROE of 14.4% (although the largest five institutions show substantially higher numbers). Moreover, I see few prospects to increase profitability. Interest rates are more likely to go down as a result of competition. MFIs might not be able to sustain such record high level of asset quality over the long time, as we have seen in other fast growing markets. Finally, there isn’t much room for increased equity leverage as NBFCs already have a 7.2x debt-to-equity ratio, more than double the global average for NBFC.

Second, overvaluation might be driven by excess capital flows. A significant share of equity investment in India comes from investors whose objective is to realize profits by floating or otherwise exiting their investments in a relatively short time frame. In many cases in the past this type of capital has produced overvaluation of equity prices in the short term and disappointment in the long term. After all, India is the only microfinance market that has attracted large private equity funds.

But I might be missing the upside. Perhaps investors are expecting MFIs to boost profits through other ways, for example, they might value MFI extensive distribution platforms for goods and services beyond finance?

I recognize that our dataset is limited and may not be representative of all MFI equity deals in India. A number of domestic microfinance investors, such as SIDBI, are known for investing at lower valuations. Thus, opportunities for reasonably-valued equity investments still remain, but the majority of recent transactions by foreign-owned funds suggest that finding such opportunities is not necessarily an easy task.