An interesting question here is: what ROE do you think Nubank can deliver on a sustainable basis? It is key to this valuation exercise because if Nubank grows 20% CAGR (as you assume) but delivers 30% or 40% ROE on a sustained basis then it will generate a lot of excess cash (that you are not including in this valuation either in the form of dividends or share buy-backs). Nubank currently reports an ROE of 28% but this is dramatically understated because they hold a lot of excess capital (both at a country level and at a holding level) and because Mexico and Columbia currently have very low ROE at an early stage of their growth. They disclose that the underlying ROE of Brazil (assuming no excess capital) would be 80%. So, it would not be too aggressive to assume that they could deliver a sustainable ROE above 40% (this is also what you are implying with a significant rise in their net margin in your assumptions). With a 40% ROE then they could easily over time return half of their profits to shareholders (to grow 20% they could return half of their 40% ROE and their equity would still grow 50% x 40%= 20%). I wouldn’t be surprised if their ROE was well in excess of 40% given the 80% ROE delivered in Brazil at a fairly early stage of their development (with still potential for large increases in revenue per customer) so they could either grow much faster than you are expecting (25 or 30% CAGR potentially by entering additional markets outside of Latam) or could return even more cash to shareholders than 50% of their profits
I have to push back on the idea that excess cash is not being captured in this valuation. The present value of net earnings represents the cash that can be returned to shareholders. Net earnings are used as a proxy instead of free cash flow because a bank’s free cash flow is heavily distorted by working capital requirements, with cash serving as both an input and an output.
The intrinsic value of a company is ultimately the present value of its future cash flows, and that’s what this model aims to capture. It is then up to the company to decide what it does with the cash it generates.
If that is so, how does the ROE achieved by Nubank drive its valuation? If that ROE was 15% then with a 20% cagr in revenues the company would be consuming its excess cash reserves whereas with a 30% or 40% roe it would be generating excess cash. The higher its roe the more excess cash it will generate. The way your model is built does not factor in the level of ROE of the business and therefore the level of excess cash generated for a certain level of growth
To value a bank using ROE, you typically rely on traditional bank valuation metrics such as the Price-to-Book (P/B) ratio. A higher ROE generally corresponds to a higher P/B. The cost of equity is another key assumption in this approach.
I don’t believe NU is at a mature enough stage to be valued this way yet, so I’ve chosen to value it more like a high-growth platform business. Just take a look at its current P/B ratio compared to the competition, and you’ll see what I mean.
There’s no right or wrong approach here. It’s an art, not a science.
I agree with you that a p/b ratio valuation only works with low growth banks but I think that for a high growth business ROE should be one of the drivers of a discounted earnings model as a higher ROE could either translate into large share buy-backs (which would add to eps growth), to dividend yield (additional return in addition to the earnings growth) or into additional growth because the company build a large amount of excess cash that it can use to make acquisitions, enter new countries or go into additional market segments (they have been making a push into e-commerce for example)
P/B (based on ROE) and discounted cash flow analysis are ultimately two conflicting valuation methods. Both can be used in isolation, but you can't create a mishmash of the two. If you want to value a company using ROE, then you need to use the P/B approach.
You can actually use ROE as a key assumption in your valuation model when you are forecasting earnings and discounting them back. However, after further review of your model I realized that it has another key issue. You are adding in your valuation the present value of ALL earnings generated every year. That would only work if your business was not growing and if you could return all earnings to shareholders. However, since this is a fast-growing business, a large share of the earnings need to be reinvested in the business and are not available to return to shareholders. What you should add to your valuation model and discount back is the “excess cash” (available each year in the form of dividends or share buy-backs). However, this excess cash depends on the ROE and growth rate of the business every year (which is why ROE is a key variable here). If growth rate > ROE in a given year then there is no excess cash generated that is available to return (and the business has to increase its leverage). If growth rate slows down below ROE then some excess cash can be generated and therefore included in a valuation model.
As an investor, I’m a big fan of David Vélez and the competitive advantages the bank has built.
That said, I do have some doubts about the growth projections - I think there are some structural barriers that might make it harder to replicate the business model in other Latin American countries. What's your take?
My projections are based on the data we have from other Latin American countries. At the moment, NU has achieved higher penetration in Mexico and Colombia compared to the same periods following its launch in Brazil.
I’d argue you’re not considering the second order impacts of Tariffs. Mexico and Brazil are both among the biggest exporters to US…tariffs in general will harm both economies and therefore potentially impact NU
This falls under emerging market risk for me and is reflected in the 15% discount rate, which is on the high end. A global recession would affect every company as a second-order impact but should not influence the long-term valuation of a company.
An interesting question here is: what ROE do you think Nubank can deliver on a sustainable basis? It is key to this valuation exercise because if Nubank grows 20% CAGR (as you assume) but delivers 30% or 40% ROE on a sustained basis then it will generate a lot of excess cash (that you are not including in this valuation either in the form of dividends or share buy-backs). Nubank currently reports an ROE of 28% but this is dramatically understated because they hold a lot of excess capital (both at a country level and at a holding level) and because Mexico and Columbia currently have very low ROE at an early stage of their growth. They disclose that the underlying ROE of Brazil (assuming no excess capital) would be 80%. So, it would not be too aggressive to assume that they could deliver a sustainable ROE above 40% (this is also what you are implying with a significant rise in their net margin in your assumptions). With a 40% ROE then they could easily over time return half of their profits to shareholders (to grow 20% they could return half of their 40% ROE and their equity would still grow 50% x 40%= 20%). I wouldn’t be surprised if their ROE was well in excess of 40% given the 80% ROE delivered in Brazil at a fairly early stage of their development (with still potential for large increases in revenue per customer) so they could either grow much faster than you are expecting (25 or 30% CAGR potentially by entering additional markets outside of Latam) or could return even more cash to shareholders than 50% of their profits
I have to push back on the idea that excess cash is not being captured in this valuation. The present value of net earnings represents the cash that can be returned to shareholders. Net earnings are used as a proxy instead of free cash flow because a bank’s free cash flow is heavily distorted by working capital requirements, with cash serving as both an input and an output.
The intrinsic value of a company is ultimately the present value of its future cash flows, and that’s what this model aims to capture. It is then up to the company to decide what it does with the cash it generates.
If that is so, how does the ROE achieved by Nubank drive its valuation? If that ROE was 15% then with a 20% cagr in revenues the company would be consuming its excess cash reserves whereas with a 30% or 40% roe it would be generating excess cash. The higher its roe the more excess cash it will generate. The way your model is built does not factor in the level of ROE of the business and therefore the level of excess cash generated for a certain level of growth
To value a bank using ROE, you typically rely on traditional bank valuation metrics such as the Price-to-Book (P/B) ratio. A higher ROE generally corresponds to a higher P/B. The cost of equity is another key assumption in this approach.
I don’t believe NU is at a mature enough stage to be valued this way yet, so I’ve chosen to value it more like a high-growth platform business. Just take a look at its current P/B ratio compared to the competition, and you’ll see what I mean.
There’s no right or wrong approach here. It’s an art, not a science.
I agree with you that a p/b ratio valuation only works with low growth banks but I think that for a high growth business ROE should be one of the drivers of a discounted earnings model as a higher ROE could either translate into large share buy-backs (which would add to eps growth), to dividend yield (additional return in addition to the earnings growth) or into additional growth because the company build a large amount of excess cash that it can use to make acquisitions, enter new countries or go into additional market segments (they have been making a push into e-commerce for example)
P/B (based on ROE) and discounted cash flow analysis are ultimately two conflicting valuation methods. Both can be used in isolation, but you can't create a mishmash of the two. If you want to value a company using ROE, then you need to use the P/B approach.
You can actually use ROE as a key assumption in your valuation model when you are forecasting earnings and discounting them back. However, after further review of your model I realized that it has another key issue. You are adding in your valuation the present value of ALL earnings generated every year. That would only work if your business was not growing and if you could return all earnings to shareholders. However, since this is a fast-growing business, a large share of the earnings need to be reinvested in the business and are not available to return to shareholders. What you should add to your valuation model and discount back is the “excess cash” (available each year in the form of dividends or share buy-backs). However, this excess cash depends on the ROE and growth rate of the business every year (which is why ROE is a key variable here). If growth rate > ROE in a given year then there is no excess cash generated that is available to return (and the business has to increase its leverage). If growth rate slows down below ROE then some excess cash can be generated and therefore included in a valuation model.
Thank you.
My pleasure
As a customer, I’m a big fan of Nubank’s service.
As an investor, I’m a big fan of David Vélez and the competitive advantages the bank has built.
That said, I do have some doubts about the growth projections - I think there are some structural barriers that might make it harder to replicate the business model in other Latin American countries. What's your take?
My projections are based on the data we have from other Latin American countries. At the moment, NU has achieved higher penetration in Mexico and Colombia compared to the same periods following its launch in Brazil.
I’d argue you’re not considering the second order impacts of Tariffs. Mexico and Brazil are both among the biggest exporters to US…tariffs in general will harm both economies and therefore potentially impact NU
This falls under emerging market risk for me and is reflected in the 15% discount rate, which is on the high end. A global recession would affect every company as a second-order impact but should not influence the long-term valuation of a company.