IndusInd Bank: The high cost of cheap valuation

IndusInd Bank 's rise looked like a rare success story—steady growth, impressive profits, and solid fundamentals that few banks could match. It was the kind of investment opportunity many dreamed of: strong performance combined with an attractive price tag. Yet, beneath this polished facade lurked hidden cracks that few spotted in time. What seemed like a straightforward, safe bet turned into a complex puzzle—one that unravelled investor trust and exposed the risks of banking's often opaque world.

Quality, growth, and profitability

For five years, IndusInd Bank demonstrated what appeared to be rock-solid fundamentals . Its Non-Performing Assets (NPAs) remained relatively stable, and its Capital Adequacy Ratio (CAR) consistently exceeded regulatory requirements, signalling a well-capitalised institution with sound asset quality. The bank's loan book expanded healthily year after year, and net profit showed a steady upward trend.

Profitability metrics were respectable, with the bank's Return on Assets (ROA) hovering around 1.5 per cent and Return on Equity (ROE) near 15 per cent, both indicators of efficient use of capital and assets. These numbers positioned IndusInd as a well-run and profitable bank.

Despite these strengths, IndusInd Bank consistently traded at a valuation discount compared to larger peers. Its price-to-book (P/B) ratio was often around 2, and its price-to-earnings (P/E) ratio hovered near 15. This perceived "cheapness" drew in investors looking for value opportunities. The growing confidence was reflected in the increasing number of retail shareholders, from under 4 lakh in early 2023 to more than 6 lakh by the end of 2024. Domestic institutional holdings also rose from roughly 25 per cent to over 40 per cent during the same period.

Could investors have seen trouble coming?

In hindsight, some early warning signs were present, but they were easy to dismiss. The 2018 NBFC and infrastructure crisis had dented the banking sector broadly, and IndusInd Bank was no exception. The bank experienced some stress on asset quality during this period.

In 2021, a whistleblower exposed concerns about loan evergreening within IndusInd's microfinance subsidiary, Bharat Financial Inclusion. Evergreening involves extending new loans to cover repayments of existing ones, which can mask underlying credit stress. This raised red flags about governance and risk controls.

However, these issues were largely seen as temporary blips, not systemic faults. The market's optimism prevailed, buoyed by the bank's historical strength and growth track record.

FY25: Warning signs amplify

In the second and third quarters of FY25, the bank's microfinance portfolio showed rising defaults—a sector-wide challenge. Yet, investors viewed these losses as short-term and anticipated a quick resolution.

Valuations contracted further. The P/B ratio dipped below 2, and the P/E ratio hovered near 10. This low valuation enticed investors hoping for a recovery and a rerating.

The unexpected blow: Derivative losses and accounting irregularities

Then, on March 10, the bank disclosed a massive shock: derivative-related accounting discrepancies led to the reversal of Rs 1,960 crore of other income.

An internal audit revealed Rs 423 crore of revenue errors in the microfinance business. The bank also uncovered unsubstantiated increases in other assets and liabilities totalling Rs 595 crore, though these did not immediately affect profits.

More alarmingly, microfinance slippages surged by Rs 3,509 crore, accompanied by a Rs 178 crore interest income reversal. The bank reclassified Rs 760 crore from interest income to other income, and Rs 158 crore from provisions to other expenses—changes with no immediate P&L impact but significant for transparency.

To put this in perspective, this is a bank managing public deposits worth Rs 4 lakh crore. The cumulative effect of these disclosures led to a net loss in Q4, ending a long streak of profitability. The "perfect" financial picture was revealed to have hidden cracks.

Lessons for long-term investors

IndusInd Bank's experience highlights a crucial lesson: a stock that appears cheap without clear reasons can be riskier than one that trades cheap due to visible poor fundamentals.

Many investors were blindsided by hidden risks, illustrating how difficult it is to fully assess financial companies. Warren Buffett's words capture this complexity perfectly:

" In a bank, it basically is whether the loans are any good. And I've been on the boards of banks. And I've gotten surprises. It's tough to tell. If you're analysing something like WD-40, or See's Candy, or our brick business, or whatever, they may have good or bad prospects, but you're not likely to be fooling yourself much about what's going on currently. But with financial institutions, it's much tougher.

Then you throw in derivatives on top of it, and no one probably knows perfectly or even within a reasonable range, the exact condition of some of the biggest banks in the world. "

This quote underscores the opaque nature of banking, especially when complex derivatives enter the picture.

The present and future outlook

While these issues appear largely one-time, and the bank's history shows resilience, trust has been severely shaken. Valuations remain low, attracting investors tempted by upside potential.

However, restoring confidence will take years. Betting on a turnaround is like travelling down a road already marked with stop signs. Investors expecting a rapid rerating may face disappointment.

A cautionary tale

IndusInd Bank's story reminds us that past performance and low valuations alone do not guarantee safety. Deep due diligence, scepticism, and patience are essential, especially in banking.

For long-term investors, it is vital to be wary of situations that seem "too good to be true" and to understand the stories behind the numbers. Only then can one navigate these complex waters safely.

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