Soochow University

Global Business Program, School of Business

Thesis

The Measurement of Chinese Banks' Intrinsic Value in its Developing Securities Market

(Student)Gareth Cottam

(Advisor) Dr. Muhan Nao () 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

Abstract
This research is motivated by the importance of valuing firms or equity.

Without an

assessment of value, price dictates an investors 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 precise 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

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.

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Table of Contents
Abstract ................................................................................................................................ i Acknowledgements ............................................................................................................. ii List of Tables ..................................................................................................................... vi List of Figures ................................................................................................................... vii I. 1.1 1.2 1.3 1.4 1.5 II. 2.1 2.1.1 2.1.2 2.1.3 2.1.4 2.1.5 2.1.6 2.2 2.2.1 2.2.2 2.2.3 2.2.4 2.2.5 2.3 2.3.1 2.3.2 2.4 2.4.1 Introduction .............................................................................................................. 1 Background and Motivation ................................................................................. 1 Purpose of the Research ....................................................................................... 3 Research Scope and Object .................................................................................. 4 Significance of the Research ................................................................................ 4 Research Process .................................................................................................. 5 Literature Review..................................................................................................... 7 Chinas Financial System ..................................................................................... 7 Chinese Banking Industry ................................................................................ 7 Monopoly to Competition. ............................................................................... 7 Non-State-Owned Commercial Banks ............................................................. 9 Key Performance Indicators (KPIs) for Banks ................................................. 9 Profit versus Profitability ............................................................................... 10 Speculative Securities Market ........................................................................ 12 Valuation scope: What is value? ....................................................................... 14 Market Value .................................................................................................. 15 Fair Value ....................................................................................................... 15 Book Value ..................................................................................................... 15 Investment Value ............................................................................................ 15 Intrinsic Value ................................................................................................ 16 Valuation objective: Why value companies? .................................................... 17 Valuation is not an exact science. ................................................................... 18 Bargains and Value......................................................................................... 19 Valuation methods: How can companies be valued? ......................................... 20 Income Approach ........................................................................................... 21 iii

2.4.2 2.4.3 2.5 2.5.1 2.5.2 2.6 III. 3.1 3.2 3.3 3.3.1 3.3.2 3.3.3 3.4 3.4.1 IV. 4.1 4.2 4.2.1 4.2.2 4.3 4.3.1 4.3.2 4.4 4.4.1 4.4.2 4.5 4.5.1 4.5.2 4.6 4.7 4.8

Market Approach ............................................................................................ 23 Asset Approach............................................................................................... 23 The Worlds Most Successful Investor .............................................................. 24 Fundamental Analysis .................................................................................... 25 Value.able ....................................................................................................... 25 Hypothesis .......................................................................................................... 26 Research Methodology....................................................................................... 28 Introduction ........................................................................................................ 28 Sampling and Data Collection............................................................................ 29 Valuation Models ............................................................................................... 30 Estimating Target Banks Value Using the Asset Approach ......................... 30 Estimating Target Banks Value Using the Market approach ........................ 30 Estimating Target Banks Value Using the Montgomery Method ................. 30 Analysis .............................................................................................................. 31 Hypothesis Testing ......................................................................................... 31

Results of the Comparison ..................................................................................... 33 Introduction ........................................................................................................ 33 Descriptive Statistics: Asset Approach .............................................................. 33 Non-State-Owned Banks ................................................................................ 33 State-Owned Banks ........................................................................................ 36 Descriptive Statistics: Market Approach............................................................ 38 Non-State-Owned ........................................................................................... 38 State-Owned ................................................................................................... 42 Descriptive Statistics: Montgomery Method...................................................... 46 Non-State-Owned ........................................................................................... 47 State-Owned ................................................................................................... 48 Market Price Comparison with Value Range ..................................................... 48 Non-State-Owned ........................................................................................... 49 State-Owned ................................................................................................... 51 Macro Economic Factors ................................................................................... 53 Results of Hypothesis Testing ............................................................................ 54 Summary of Findings ......................................................................................... 56 iv

V. 5.1 5.2 5.3 5.4 5.5 5.6

Research Findings and Conclusions ...................................................................... 58 Introduction ........................................................................................................ 58 Considerable Differences Among Various Evaluations..................................... 58 Research Implications ........................................................................................ 59 Limitations of the Research................................................................................ 59 Recommendations for Future Research ............................................................. 60 Conclusions ........................................................................................................ 61

References and Bibliography ............................................................................................ 63 Appendix ........................................................................................................................... 70

List of Tables
Table 4.2.1-1 Bank of Communications ........................................................................... 34 Table 4.2.1-2 CITIC Bank ................................................................................................ 34 Table 4.2.1-3 China Merchants Bank ............................................................................... 35 Table 4.2.1-4 Shanghai Pudong Development Bank ....................................................... 35 Table 4.2.2-1 Agricultural Bank of China ....................................................................... 36 Table 4.2.2-2 Bank of China ............................................................................................ 36 Table 4.2.2-3 China Construction Bank .......................................................................... 37 Table 4.2.2-4 Industrial and Commercial Bank of China ................................................ 37 Table 4.3.1-1 Summary of SPDB New Shares Issue Prices ............................................ 41 Table 4.4.1-1 Comparison of Non-State-Owned Banks Montgomery Intrinsic Value .. 47 Table 4.4.2-1 Comparison of State-Owned Banks Montgomery Intrinsic Value ........... 48 Table 4.5.1-1 Bank of Communications .......................................................................... 49 Table 4.5.1-2 CITIC Bank ............................................................................................... 49 Table 4.5.1-3 China Merchants Bank .............................................................................. 50 Table 4.5.1-4 Shanghai Pudong Development Bank ....................................................... 50 Table 4.5.2-1 Agricultural Bank of China ....................................................................... 51 Table 4.5.2-2 Bank of China ............................................................................................ 51 Table 4.5.2-3 China Construction Bank .......................................................................... 52 Table 4.5.2-4 Industrial and Commercial Bank of China ............................................... 52

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List of Figures
Figure 4.6-1 Comparative discrepancy between market price and intrinsic value of nonstate-owned banks ............................................................................................................. 55 Figure 4.6-2 Comparative discrepancy between market price and intrinsic value of stateowned banks...................................................................................................................... 56

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I.

Introduction

1.1 Background and Motivation

Greed is said to be a cardinal sin and yet it seems to be a recurring theme through the ages. Humanitys tendency to succumb to the love of money1 can be seen from the tulip mania in the mid-16th century, the Wall Street Crash of 1929, continuing through the 1987 Black Monday, the Asian Financial Crisis, Enron and the most recent subprime 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 & 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 & 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. Chinas economy appears to have ridden out the storm well and is an engine of growth 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 worlds second-largest economy (Hamlin & Yanping, 2010). So what is underlying the Chinese economy?

New Testament: "The love of money is the root of all evil" (1 Timothy 6:10, KJV)

While Chinas future influence on the global economy will undoubtedly increase, this should be tempered with an understanding that China is still a developing nation. Chinas current financial system is dominated by a large banking sector that has been accused of being inefficient and poorly regulated (Allen, Qian, Zhang, & 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. By 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 funds. (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 worlds largest bank by assets and valuation while still majority state-owned (Hamlin & Yanping, 2010). Is this a cause for concern? What does market capitalization mean? According to Berk and DeMarzo (2007), market capitalization is the total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying a company's shares outstanding by the current market price of one share. The investment community uses this figure in determining a company's size, as opposed to sales or total asset figures. Given the

speculative nature of Chinas developing securities markets (Wang & Xu, 2004) (Liu & 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: Greed is good. 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?

1.2 Purpose of the Research

The purpose of this paper is to apply appropriate valuation methodologies in an attempt to measure the intrinsic value of Chinas 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 precise 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 Chinas 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

data including the year 2010. The data on each banks' market price for comparison were sourced from the Shanghai Exchange database.

1.3 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 Chinas 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.

1.4 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.

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.

1.5 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 Chinas 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:

Interpret the results of the data analysis, state conclusions and provide recommendations.

II. Literature Review This section reviews the literature regarding Chinas 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.

2.1 Chinas Financial System

China is considered a rapidly developing country with boundless opportunities yet Chinas 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?

2.1.1 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.

2.1.2 Monopoly to Competition.

Between 1950 and 1978, Chinas financial system consisted of a single bank the Peoples Bank of China (PBOC), a central government-owned and controlled bank under the Ministry of Finance.(Brandt & Rawski, 2008). Due to government restrictions, the PBOC was a monopoly, its main role was to finance physical production plans,

controlling about 93 percent of the total financial assets of the country and handling almost all financial transactions. (Berger, Hasan, & 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 Chinas 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 China's 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. Since 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 13.6% of total financial sector assets. (Wu & 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, Chinas banking system is still mainly controlled by the four largest state-owned banks, with over 50 percent share of

total banking assets between them2. All of these Big Four banks have become publicly listed and traded companies in recent years, with the government being the largest shareholder and retaining control.

2.1.3 Non-State-Owned Commercial Banks

Wen (2008) defines 12 commercial banks in China as non-state-owned commercial banks. To be considered a non-state-owned commercial banks, 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)

2.1.4 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

Things seem to be starting to change with the decreasing weight of state-owned commercial banks in the banking system (with 73.9 percent of the total assets in 1993 and 54.6 percent in 2004 and remain at this level currently). People's Bank of China: Financial Stability Report 2010 - Source: People's Bank of China

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.

2.1.5 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

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making their investments. (McGuigan, Moyer, & Harris, 2007) However, the majority ownership of the Chinese banking industry is still in the governments 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, & 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. 11

Montgomery (2010) argues that while profits are important, the amount of equity required to generate that profit is of greater importance. A companys 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.

2.1.6 Speculative Securities Market

Chinas two domestic stock exchanges, the Shanghai Stock Exchange (SHSE) and Shenzhen Stock Exchange (SZSE), were established in 1990 (Allen, Qian, Zhang, & Zhao, 2010). Their scale and importance are not comparable to the banking sector, and they have not been effective in allocating resources in the economy, in that they are highly speculative and driven by insider trading. (Berger, Hasan, & Zhou, 2008) Wang and Xu (2010) argue that with the sustainable development of China's economy, China's 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 China's securities market is clearly visible and therefore, it is of important theoretical and practical significance to research on behavioral finance features of China's 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, 12

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, & 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 & 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
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 Chinas 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.
3

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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 (i.e. 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 & 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.

2.2 Valuation scope: What is value?

The definition of value 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

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These standards of value are defined as follows:

2.2.1 Market Value

The 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 arms 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 facts. International Glossary of Business and Valuation Terms (International Glossary) (2001)

2.2.2 Fair Value

The 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 sale (Hitchner, 2003) or more directly, the term fair value is usually a legally created standard of value that applies to certain specific transactions (Pratt, Reilly, & Schweihs, 2000)

2.2.3 Book Value

With 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 Shareholder's Equity). International Glossary (2001) It is important to note that the firms book value may be an unreasonable measure of its true value because of the idiosyncrasies of accounting.

2.2.4 Investment Value

The International Glossary defines investment value as The value to a particular investor based on individual investment requirements and expectations. Hitchner (2003) 15

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.

2.2.5 Intrinsic Value

Hitchner (2003) defines intrinsic value as the amount an investor considers to be the true or real worth of an item, based on an evaluation of available facts It is an analytical judgment of value based on perceived characteristics inherent to the investment. Graham et al (1988) states a general definition of intrinsic value would be that value which is justified by the facts, eg., assets, earning, dividends, definite prospects, including the factor of management. Given the dynamic nature of business, the primary objective is to emphasize the distinction between value and current market price but not to invest value with an aura of permanence. 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

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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?

2.3 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. Graham who said: Investing, 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 This can be better summarized by Benjamin

security analyst, the number of variables remains almost infinite, and the judgment factor still dominates investment decisions. (Graham, Dodd, Cottle, Murray, & 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.

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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 one mans trash is another mans treasure. 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.

2.3.1 Valuation is not an exact science.

Valuation rests on assumptions. By definition, the choice of assumptions in a valuation report requires the professional judgment of the valuator The value can be higher or lower if certain critical assumptions are changed. (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 18

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 (e.g., 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 investors 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.

2.3.2 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 markets 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. The Graham and Dodd approach, however, takes the view that the markets 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 fluctuate. (Graham, Dodd, Cottle, Murray, & Block, 1988)

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In everyday life, we talk about getting value for money. 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 no. Benjamin Graham often referred to as the father of value investing and followers of his teachings would say yes. 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.

2.4 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 20

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 studys particular situation. The following are a selection of the various valuation methods grouped and defined, including pros and cons of each method.

2.4.1

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 & 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 19971999. They document that 99.1 percent of analysts mention the use of some kind of earnings multiples, 12.8 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.

21

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 analysts 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. If a company doesnt pay all of its earnings out as a dividend, there are a potentially large amount of earnings that are retained, and the DDM doesnt 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 doesnt value these retained earnings.

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2.4.2 Market Approach

The comparable sales approach focuses on sales of similar businesses in arm's-length transactions (Lokey & 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 buyers 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 buyers 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.

2.4.3 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 & 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 & Hudson, 1987) While employees are not capitalized on the balance sheet, they are often a firm's

Such as, strategic alliances or joint ventures in the credit card business and so forth.

23

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.

2.5 The Worlds 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 random walk and Efficient Market Hypothesis (EMH). Despite his argument and presented evidence (Buffett, 1984), nothing further was researched and it seems Warren Buffetts achievements as an investor have been dismissed as an accident or fluke 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 Buffetts 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
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.
6

24

has a sufficient margin of safety. Few books have been able to figure out what Warren Buffetts real secret formula 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-andDoddsville, Buffett (1984) states that "Graham and Dodd investors do not discuss beta, the capital asset pricing model or covariance in returns among securities. They simply focus on two variables: price and value.

2.5.1 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 A method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors.

2.5.2 Value.able
While Warren Buffett has never revealed his formula for valuing a company, his annual chairmans letters contain great insight into his investment philosophy. In Roger

Montgomerys book Value.able, Montgomery (2010) discusses two methods derived from Buffetts writings and presents two valuation tables (reproduced in Tables 2.1 and 2.2 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 Chairmans letter to Berkshire Hathaway shareholders, applying to a company that pays out all earnings as dividends. The second table presented by Montgomery (2010) is

25

derived from the formula suggested by Richard Simmons book, Buffett step-by-step: an investors workbook learn to analyze and apply the techniques of the master investor, 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.

2.6 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 Chinas developing securities market. This study hypothesizes that the speculative nature of Chinas 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.

26

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.

27

III.

Research Methodology

3.1 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 Buffetts success as an investor, Montgomerys adaptation derived from Warren Buffets 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.

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3.2 Sampling and Data Collection

A total of 8 banks listed on the Shanghai Stock Exchange were analyzed. These banks consist of the Big Four state-owned banks; Agricultural Bank of China, Bank of China, China Construction Bank, Industrial and Commercial Bank of China and four non-stateowned banks; Bank of Communications, CITIC Bank, China Merchants Bank and Shanghai Pudong Development Bank. Firms data on total assets, liabilities, earnings and other relevant financial data were extracted and calculated from firms 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.

For example, Reuters, Thompsons and Morningstar

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3.3 Valuation Models 3.3.1 Estimating Target Banks 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 assets 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.

3.3.2 Estimating Target Banks 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.

3.3.3 Estimating Target Banks 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 essential ingredient in establishing the economic performance of the business. 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 banks balance sheets and statements of cash flow.

30

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 investors required return of 10% as suggested for illustrative purposes by Montgomery (2010). The researcher will then use these two figures in both Tables 2.1 and 2.2, to determine the appropriate multiplier to apply to each banks 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 2.1 by the payout ratio8. Second multiply the result obtained from using Table 2.2 by one minus the payout ratio. The addition of the two results will arrive at an estimated intrinsic value for the bank.

3.4 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.

3.4.1 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

Calculated as Dividends per Share divided by Earnings per Share.

31

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 banks 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

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IV.

Results of the Comparison

4.1 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 banks 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.

4.2 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 companies annual reports obtained from the investor relations section of each banks 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.

4.2.1 Non-State-Owned Banks

The following tables illustrate the total asset and liability data collected for the non-stateowned banks.

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Table 4.2.1-1 Bank of Communications

Bank of TotalAssets Communication 2010 2009 2008 2007 2006 2005 2004 3,951,593 3,309,137 2,682,947 2,110,444 1,719,483 1,423,439 1,144,005

TotalLiabilities Remaining Equity 3,727,936 3,144,712 2,532,852 1,977,123 1,628,988 1,340,293 1,091,902 223,657 164,425 150,095 133,321 90,495 83,146 52,103

Equity Share

Per

3.98 3.36 3.06 2.72 1.98 1.82 1.14

Table 4.2.1 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 3.98 RMB.

Table 0-2 CITIC Bank

CITICBank 2010 2009 2008 2007 2006 2005

TotalAssets 2,081,314 1,776,276 1,319,570 1,011,186 706,723 594,602

TotalLiabilities 1,956,776 1,668,023 1,190,196 927,095 675,029 571,377

RemainingEquity EquityPerShare 124,538 108,253 129,374 84,091 31,694 23,225 3.19 2.77 3.31 2.15 1.02 0.75

Table 4.2.2 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 3.19 RMB.

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Table 0-3 China Merchants Bank

Merchants Bank 2010 2009 2008 2007 2006 2005

TotalAssets

TotalLiabilities

Remaining Equity 134006 92783 79781 68396 55160 25998

EquityPerShare

2402507 2067941 1571797 1310964 934102 734613

2268501 1975158 1492016 1242568 878942 708615

6.21 4.85 5.42 4.65 3.75 2.51

Table 4.2.3 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 6.21RMB.
Table 0-4 Shanghai Pudong Development Bank

Pudong Development Bank 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997

Total Assets 2,191,411 1,622,718 1,309,425 914,980 689,358 573,523 455,532 371,057 279,301 173,691 111,591 103,210 84,926 81,496

TotalLiabilities

Remaining Equity 123,280 68,087 41,702 28,298 24,720 15,969 13,510 12,011 7,960 7,067 2,394 7,776 3,255 13,589

EquityPerShare

2,068,131 1,554,631 1,267,724 886,682 664,638 557,553 442,022 359,046 271,340 166,624 109,197 95,434 81,671 67,908

8.59 7.71 7.37 6.50 6.25 4.08 3.45 3.07 2.20 2.93 0.99 3.23 1.62 6.76

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Table 4.2.4 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 8.59.

4.2.2 State-Owned Banks

Table 4.2.2-1 Agricultural Bank of China

Agricultural Bankof China 2010 2009 2008 2007

TotalAssets

TotalLiabilities

Remaining Equity 542236 342925 290541 727605

EquityPerShare

10,337,406 8,882,588 7,014,351 5,305,506

9,795,170 8,539,663 6,723,810 6,033,111

1.67 1.32 1.12 2.80

Table 4.2.5 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 1.67RMB.

Table 4.2.2-2 Bank of China

BankofChina TotalAssets

TotalLiabilities

RemainingEquity EquityPerShare

2010 2009 2008 2007 2006 2005 2004

10459865 8748177 6951680 5991217 5327653 4740048 4270443

9783715 8206549 6461793 5540560 4914697 4484529 4037705

676150 541628 489887 450657 412956 255519 232738

2.42 2.13 1.93 1.78 1.63 1.22 1.25

The Ministry of Finance of the People's 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 banks balance sheets prior to publicly listing. In the case of the Agricultural Bank of China, the Great Wall AMC was created.

36

Table 4.2.6 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 2.42RMB.

Table 4.2.2-3 China Construction Bank

Construction TotalAssets Bank

TotalLiabilities

Remaining Equity

EquityPerShare

2010 2009 2008 2007 2006 2005 2004

10810317 9623355 7555452 6598177 5448511 4585742 3909920

10109412 9064335 7087890 6175896 5118307 4298065 3714369

700905 559020 467562 422281 330204 287677 195551

2.80 2.39 2.00 1.81 1.47 1.28 1.01

Table 4.2.7 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 2.80RMB.
Table 4.2.2-4 Industrial and Commercial Bank of China

ICBC

TotalAssets

TotalLiabilities

Remaining Equity 821657 678,934 606,630 543,676 471,001 259,876 (508,045)

EquityPerShare

2010 2009 2008 2007 2006 2005 2004

13,458,622 11,785,053 9,757,146 8,683,712 7,508,751 6,456,131 5,069,324

12,636,965 11,106,119 9,150,516 8,140,036 7,037,750 6,196,255 5,577,369

2.35 2.03 1.82 1.63 1.41 1.05 2.05

Table 4.2.8 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

37

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 2.35RMB.

4.3 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.

4.3.1 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 19.9% of the Bank of Communications. HSBC held 7.77 billion shares in the bank purchased for 1.86 RMB per share, 1.49 times the

10

The Huarong AMC was created to handle assume the non-performing assets, primarily NPLs of ICBC.

38

company's 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 1,396,802,037 H-rights shares at HK$5.14 per share ( approximately 4.48RMB per share). The transaction represented a consideration of approximately HK$7,180 million thereby maintaining HSBCs 19.9% 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 banks sole strategic investor and purchased 4.83% of CITIC shares at 3.42RMB per share. This was approximately a 40% discount to the IPO issue price of 5.80RMB. The IPO value range was set at HK$5.06-HK$5.86, while the range for the Shanghai-listed shares was set between 5.00RMB to 5.80 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 2.75 times its 2007 book value from 2.81 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 Red Chip11 financial stocks. It dropped below the IPO price, HK$5.80, and closed at HK$5.79 on 5 June 2007.

11

A stock in a company operating in the People's 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.

39

In 2009, BBVA increased its shareholding in the Bank on two consecutive occasions up to 15% of total shares, first, up to 10.07% on February 2009, and up to 15%12 later with the transaction closing on April 1st, 2010. The option was executed at HKD 6.45 per share13, a price comparable to that of the initial IPO price. China Merchants Bank China Merchants Bank initial public offering was 1.5 billion common shares in RMB (A Shares) at an issue price of 7.30RMB per share on Shanghai Stock Exchange on 27 March 2002. The Hong Kong IPO issued 2.2 billion overseas listed foreign currency denominated shares (H shares) on 22 September 2006 at HK$8.55 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 & Master, 2010) China Merchants Bank set an A-share rights issue price of 8.85 RMB per share compared with a closing price of 16.3 RMB of its A shares listed on the Shanghai Stock Exchange at the time of announcement.

12 13

By exercising its share option from a Share and Option Agreement entered into on 22 November 2006. Approximately 5.86RMB based on 2009 HKD to RMB exchange rate 22 day average(1 HKD = 0.880675 CNY) 14 Approximately 8.42RMB per share based on September 2006 average exchange rate.

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Shanghai Pudong Development Bank On September 23, 1999 the Shanghai Pudong Development Bank (SPDB) issued 400,000,000 ordinary shares (Share A) to general public in China with issue price of 10.00RMB 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 8.45RMB for each share. On November 16, 2006, the bank issued additional A share 700 million shares with an issue price of 13.64RMB 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 16.59RMB per share.
Table 4.3.1-1 Summary of SPDB New Shares Issue Prices

Year September,1999 December,2002 November,2006 September,2009

Price(RMB) 10.00 8.45 13.64 16.59

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 3.32RMB 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 Shanghai's Jiushi Company and SPDB non-circulating shares, taking its stake in SPDB up to 24.9 percent. However, Citigroup has not raised its ownership stake and in 2006 reduced it slightly to 3.78%. In 2008, SPDB implemented a profit distribution plan of 4 bonus shares for every 10 shares during the period and Citibank's percentage holding was further reduced to 3.39%.

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4.3.2 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 Limiteds 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 Chartereds 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 0.37% 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 2.68 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 RBS), Asia Financial Holdings Pte. Ltd15. (AFH), UBS AG (UBS) and the Asian Development Bank (ADB). According to the Bank of China's 2005 annual report, by the end of 2005, RBS held 20,942,736,236 shares, accounting for 10% of the Bank's total equities, AFH held 10,471,368,118 shares or 5% total equity, UBS AG held 3,377,860,684 shares or about 1.6129% equity and the ADB held 506,679,102 shares, approximately, 0.2419% 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.

42

Bank's total equities. The Bank issued ordinary shares to each strategic investor at 1RMB per share. The listed IPO issue price was 3.08RMB per share. RBS' contractual commitment to retain the 4.26% 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 4.26% investment in Bank of China was sold for HKD 18.4 billion, approximately HK$1.7116 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 3.4 billion Bank of China Limited H-shares to institutional investors for a cash consideration of approximately CHF 887 million (HKD 6,519 million). The sale values each share at approximately 1.93HKD or about 1.70RMB. China Construction Bank According to China Construction Banks 2005 Annual Report, the Bank entered into strategic investment and cooperation agreements with Bank of America Corporation (Bank of America) on 17 June 2005, and an investment agreement with Asia Financial Holdings Pte. Ltd. (AFH), on 1 July 2005. According to Bank of Americas 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 $3.0 billion. The initial purchase of CCB shares for $2.5 billion in August 2005 and during CCBs initial public offering in October 2005, made an

16

Approximately 1.55RMB per share

43

additional purchase of $500 million. As the float on the Hong Kong stock exchange had an issue price of HK$2.35 per share (approximately 2.25RMB per share), it is calculated that initial purchase of CCB shares was between 0.84 and 0.86RMB per share17 According to CCBs 2008 Annual Report, on 25 September 2007, the Bank issued 9 billion A-shares in its domestic IPO at an issuance price of 6.45RMB. According to CCB and Bank of Americas 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 6,000,000,000 H-shares and 19,580,153,370 H-shares of the Bank respectively from Huijin purchasing 25.6 billion common shares for approximately $9.2 billion paying approximately 2.97RMB per share. In addition in January 2009, Bank of America sold 5.6 billion common shares of their initial investment in CCB for $2.8 billion, for approximately 4.14RMB per share. Later in 2009, Bank of America sold 19.1 billion common shares representing their entire initial investment in CCB for $10.1 billion, approximately 4.38RMB 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 18

Allowing for fluctuations in exchange rates dating back to the dates of the IPO. State-owned holder of the majority of CCBs ordinary shares.

44

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 16,476,014,155 shares, 6,432,601,015 shares and 1,276,122,233 shares newly issued by the Bank on 28 April 2006 for a consideration of USD 2,582.2 million, EUR 824.7 million and USD 200 million, respectively (on the basis of an agreed exchange rate of USD1 to RMB 8.0304 and EUR 1 to RMB 9.8167). Each investor paid 1.26RMB per share. On 29 June 2006, SSF19 subscribed for 14,324,392,623 shares newly issued by the Bank for a consideration of approximately RMB 18 billion, or 1.26RMB 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 Hshares were RMB 3.12 and HKD 3.07 per share. The offering prices for A-shares and Hshares 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 3,216,300,507 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 3.86 HKD per share20. Allianz continues to hold 3,216,300,508 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 638.06 million shares also at HK$ 3.86 a
The National Social Security Fund (SSF) is a fund set up by the PRC government to provide social security for the nations aging population and to support economic development and social stability. 20 Between 3.38 and 3.40RMB per share.
19

45

share through private sales. At the end of September 2010, Goldman Sachs sold 3.04 billion ICBC shares at HK$ 5.7421 each. According to the ICBCs 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 0.45 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 2.99 per A rights share and HK$ 3.49 per H rights share, which were the same after exchange rate adjustment. The subscription price per A rights share of RMB 2.99 represented a discount of approximately 36.9% to the closing price of RMB 4.74 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$ 3.49 represented a discount of approximately 47.4% to the closing price of HK$6.63 per H share as quoted on SEHK on the price determination date.

4.4 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 banks annual reports. The IV is then compared with the listed share price for each bank, as of December 31st for each year.

21

Approximately 5.01RMB per share

46

4.4.1 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 4.4.1-1 Comparison of Non-State-Owned Banks Montgomery Intrinsic Value Shanghai Pudong Development Bank

IV 2010 5.87 2009 3.84 2008 5.86

HSBC23 Share Price 10.25 11.53 8.75 16.89 18.30 16.06

2007 20.23 2006 17.44 2005 18.19

CITICBank Share IV SharePrice IV Price 12.21 5.56 9.99 5.25 10.02 9.35 3.83 8.23 8.24 4.74 4.46 3.86 6.49 15.62 4.47 10.15 3.81 1.52 2.62 1.11

Bankof Communication

Merchants Share IV Price 24.49 12.81 14.58 18.05 29.80 12.16 22.65 39.63 6.78 16.36 3.62

IV 29.04 38.07 67.76 21.53 12.43 10.42

Share Price 12.39 21.69 13.25 52.80 21.31 9.75

As shown in Table 4.4.1, the banks 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 23

HSBCs financial data is reported in US dollars. As with most global banks, it appears HSBCs intrinsic value was impacted in the years of the GFC .

47

4.4.2 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 4.4.2-1 Comparison of State-Owned Banks Montgomery Intrinsic Value

HSBC IV 2010 5.87 2009 3.84 2008 5.86 2007 20.23 2006 17.44 2005 18.19 Share Price 10.25 11.53 8.75 16.89 18.30 16.06

Agricultural BankofChina IV 4.98 3.99 0.32 0.80 Share Price 2.68 2.70

BankofChina IV 5.43 3.67 Share Price 3.23 4.33 2.97 6.61 5.43

ChinaConstruction Bank IV 8.26 7.68 5.66 3.59 2.93 1.89 Share Price 4.59 6.19 3.83 9.85 IV

ICBC Share Price 4.24 5.44 3.54 8.13 6.20

8.46 5.75 5.21 4.11

3.26 3.01 2.92

1.47

2.54 1.54

As shown in Table 4.4.2, 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.

4.5 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

HSBCs financial data is reported in US dollars.

48

4.5.1 Non-State-Owned
Table 4.5.1-1 Bank of Communications

Bankof Communications 2010 2009 2008 2007 2006 2005JanPreIPO 2004

Asset

Market

Montgomery Dec31st IV SharePrice 12.21 10.02 8.24 6.49 3.81 2.62 1.14 5.56 9.35 4.74 15.62

6Month AverageShare Price 6.01 10.70 7.87 11.83

3.98 3.36 3.06 2.72 1.98 1.82 1.14

4.48 1.86

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 4.5.1-2 CITIC Bank

CITICBank

Asset

Market

Montgomery Dec31stShare IV Price 9.99 3.83 4.46 4.47 1.52 1.11 5.25 8.23 3.86 10.15

2010 2009 2008 2007 2006 2005

3.19 2.77 3.31 2.15 1.02 0.75

5.86 3.42

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.

49

Table 4.5.1-3 China Merchants Bank

ChinaMerchants Bank 2010 2009 2008 2007 2006 2005

Asset

Market

Montgomery Dec31stShare IV Price 24.49 14.58 29.80 22.65 6.78 3.62 12.81 18.05 12.16 39.63 16.36

6.21 4.85 5.42 4.65 3.75 2.51

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 4.5.1-4 Shanghai Pudong Development Bank

ShanghaiPudong Asset DevelopmentBank 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 8.59 7.71 7.37 6.50 6.25 4.08 3.45 3.07 2.20 2.93 0.99 3.23 1.62 6.76

Market

Montgomery Dec31stShare IV Price 29.04 38.07 67.76 21.53 12.43 10.42 6.72 5.92 2.31 2.93 2.76 8.79 5.60 1.46 12.39 21.69 13.25 52.80 21.31 9.75 7.00 10.53 9.86 15.69 20.75 24.75 0.00 0.00

3.32

50

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.

4.5.2 State-Owned
Table 4.5.2-1 Agricultural Bank of China

AgriculturalBankof Asset China 2010 2009 2008 2007

Market

Montgomery Dec31stShare IV Price 2.68 4.98 3.99 0.32 0.80 2.68

1.67 1.32 1.12 2.80

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 4.5.2-2 Bank of China

BankofChina

Asset

Market

Montgomery Dec31stShare IV Price 5.43 3.67 3.26 3.01 2.92 1.47 0.00 3.23 4.33 2.97 6.61 5.43

2010 2009 2008 2007 2006 2005 2004

2.42 2.13 1.93 1.78 1.63 1.22 1.25

1.55 1.70 3.08 1.00

51

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 4.5.2-3 China Construction Bank

ChinaConstruction Bank

Asset

Market

Montgomery IV 8.26 7.68

Dec31st Share Price 4.59 6.19

6Month AverageShare Price 4.85 6.47 5.77

2010 2.80 2009sale 2.39 4.38 January2009sale 4.14 2008purchase 2.00 2.97 2007 1.81 2006 1.47 2005 1.28 2.25 June2005PreIPO 0.84~0.86RMB

5.66 3.59 2.93 1.89

3.83 9.85

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 4.5.2-4 Industrial and Commercial Bank of China

ICBC

Asset

Market 2.35

Montgomery Dec31stShare IV Price 8.46 5.01 5.75 5.44 5.21 4.11 2.54 1.54 0.00 3.54 8.13 6.2 4.24

2010 Sept2010sale 2009 March2009sale 2008 2007 2006 2006PreIPO 2005 2004

2.03 3.38~3.40 1.82 1.63 1.41 1.05 2.05

3.12 1.26

52

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.

4.6 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 BBVAs strategic aim to grow business within the Asian market and CITIC Banks 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 24.9% and their ownership stake has been diluted by capital raisings.

53

While Standard Chartered has become a cornerstone investor in the Agricultural Bank of China, its ownership stake is conspicuously small at 0.37%, this may illustrate a lack of commitment to the holding. It remains to be seen whether the banks 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.

4.7 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 Chinas 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 4.6-1. The volatility of the share price creates a large discrepancy between listed market price and estimated intrinsic values. The state-owned 54

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 4.6-2. 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 4.7-1 Comparative discrepancy between market price and intrinsic value of non-state-owned banks

60.00 50.00

80.00 70.00 60.00

40.00 30.00 20.00 10.00 2005 2006 2007 2008 2009 2010 MerchantsIV CITICBankIV BankofCommunicationSharePrice MerchantsSharePrice BankofCommunicationIV PudongIV CITICBankSharePrice PudongSharePrice

50.00 40.00 30.00 20.00 10.00

55

EstimatedIntrinsicValue

MaketSharePrice

Figure 4.7-2 Comparative discrepancy between market price and intrinsic value of state-owned banks

MarketSharePrice

8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 2005 2006 2007 2008 2009 BankofChinaIV ICBCIV BankofChinaSharePrice 2010

10.00 8.00 6.00 4.00 2.00

AgriculturalBankofChinaIV ChinaConstructionBankIV AgriculturalBankofChinaSharePrice ICBCSharePrice

ChinaConstructionBankSharePrice

4.8 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, Chinas 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. 56

EstimatedIntrinsicValue

9.00

12.00

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.

57

V.

Research Findings and Conclusions

5.1 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.

5.2 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 banks 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 4.5.1 and 4.5.2. 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.

58

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 banks balance sheets.

5.3 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.

5.4 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

59

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 stateowned 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 a continuous emotional attachment to the brand/product or service provides that ability. Given the government regulation controlling the banking sector, it is worth noting that the inability of banks (state and nonstate 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.

5.5 Recommendations for Future Research

This study utilizes the data available in annual reports in its valuation method. However; aggregated analysts predicted future earnings of listed companies could potentially be used to estimate future intrinsic values. Therefore it is suggested to study the effects of 60

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).

5.6 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.

61

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 companys 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 doesnt 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.

62

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Appendix

Table 2.1 Multiplier Selection when a Company Pays Out 100 percent of its Earnings

Company's Returnon Equity 5.00% 7.25% 10.00% 12.50% 15.00% 17.25% 20.00% 22.50% 25.00% 27.50% 30.00% 32.50% 35.00% 37.50% 40.00% 42.50% 45.00% 47.50% 50.00% 52.50% 55.00% 57.50% 60.00%

8% 0.625 0.938 1.250 1.563 1.875 2.188 2.500 2.813 3.125 3.438 3.750 4.063 4.375 4.688 5.000 5.131 5.625 5.938 6.250 6.563 6.875 7.188 7.500

Investor'sRequiredRateofReturnAfterTax 9% 10% 11% 12% 13% 0.556 0.500 0.455 0.417 0.385 0.833 0.750 0.682 0.625 0.577 1.111 1.000 0.909 0.833 0.769 1.389 1.250 1.136 1.042 0.962 1.667 1.500 1.364 1.250 1.154 1.944 1.750 1.591 1.458 1.346 2.222 2.000 1.818 1.666 1.538 2.500 2.250 2.045 1.875 1.730 2.777 2.500 2.272 2.083 1.923 3.055 2.750 2.500 2.291 2.115 3.333 3.000 2.727 2.499 2.307 3.610 3.250 2.954 2.708 2.499 3.888 3.500 3.181 2.916 2.692 4.166 3.750 3.408 3.124 2.884 4.444 4.000 3.636 3.332 3.076 4.721 4.250 3.863 3.541 3.268 4.999 4.500 4.090 3.749 3.460 5.277 4.750 4.317 3.957 3.653 5.554 5.000 4.544 4.165 3.845 5.832 5.250 4.772 4.374 4.037 6.110 5.500 4.999 4.582 4.229 6.387 5.750 5.226 4.790 4.421 6.665 6.000 5.453 4.999 4.614

14% 0.357 0.536 0.714 0.893 1.071 1.250 1.429 1.607 1.786 1.964 2.143 2.322 2.500 2.679 2.857 3.036 3.214 3.393 3.572 3.750 3.929 4.107 4.286

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Table 2.2 Multiplier Selection when a Company Retains 100 percent of its Earnings

Company's Returnon Equity 5.00% 7.25% 10.00% 12.50% 15.00% 17.25% 20.00% 22.50% 25.00% 27.50% 30.00% 32.50% 35.00% 37.50% 40.00% 42.50% 45.00% 47.50% 50.00% 52.50% 55.00% 57.50% 60.00%

Investor'sRequiredRateofReturnAfterTax 8% 0.429 0.890 1.494 2.233 3.100 4.092 5.203 6.432 7.776 9.231 10.796 12.469 14.248 16.132 18.119 20.209 22.399 24.688 27.076 29.561 32.143 34.821 37.593 9% 0.347 0.720 1.209 1.806 2.508 3.310 4.209 5.203 6.290 7.467 8.733 10.087 11.526 13.050 14.658 16.348 18.119 19.972 21.903 23.914 26.003 28.169 30.411 10% 0.287 0.596 1.000 1.494 2.075 2.738 3.482 4.305 5.203 6.177 7.225 8.344 9.535 10.796 12.126 13.524 14.989 16.521 18.119 19.783 21.511 23.302 25.158 11% 0.242 0.502 0.842 1.259 1.748 2.307 2.933 3.626 4.383 5.203 6.086 7.029 8.032 9.094 10.214 11.392 12.626 13.917 15.263 16.664 18.119 19.629 21.192 12% 0.207 0.429 0.720 1.076 1.494 1.972 2.508 3.100 3.748 4.449 5.203 6.010 6.867 7.776 8.733 9.740 10.796 11.899 13.050 14.248 15.493 16.783 18.119 13% 0.179 0.372 0.624 0.932 1.294 1.708 2.171 2.684 3.245 3.852 4.505 5.203 5.946 6.732 7.562 8.433 9.347 10.303 11.299 12.336 13.414 14.531 15.688 14% 0.157 0.325 0.546 0.815 1.132 1.494 1.900 2.349 2.840 3.371 3.943 4.554 5.203 5.891 6.617 7.800 8.180 9.016 9.888 10.796 11.739 12.717 13.729

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