SCGLF - Societe Generale: Poised For A Record Year

Summary

• At x0.4 Price to Book, Societe Generale's valuation makes little sense - especially considering the attractive interest rate environment.
• With the ECB raising the marginal lending facility likely to 4 percentage points by the end of 2023, SG is poised to see an enormous profitability tailwind.
• This tailwind could add as much as EUR12 million to Societe Generale's bottom line in 2025 as compared to 2021, according to my calculations.
• Personally, I base my valuation of Societe Generale stock on a residual earnings model and calculate a fair share price of $65.60.

Thesis

Some European banks continue to trade exceptionally cheap. One of them is surely Société Générale Société anonyme ( SCGLF , SCGLY ), priced at a Price to Tangible Book of less than x0.4. In my opinion, this steep discount to book value doesn't make much sense given the expected increase in the Euro economy's interest rate benchmark to levels likely close to 4%.

Personally, I base my valuation of Societe Generale stock on a residual earnings model and calculate a fair share price of $65.60. "Buy."

For reference, although Societe Generale stock has shown some strength recently, the bank remains a relative outperformer: for the trailing twelve months, Societe Generale stock is down approximately 18%, as compared to a loss of close to 10% for the S&P 500 (SP500).

About Societe Generale

Societe Generale is a French multinational banking and financial services company headquartered in Paris. It is one of the largest banks in Europe and offers a wide range of services including retail banking, corporate and investment banking, wealth management, and asset management. The bank's diversified exposure to the financial service industry is attractive, I argue, as the diversification provides good protection against economic challenges and market volatility. During times of low interest rates and stability, the investment banking and wealth management divisions thrive. Meanwhile, in uncertain markets, the bank's global market division is poised to perform well. Additionally, a rise in interest rates results, while pressuring investment banking activity, pushes income from retail banking.

Societe Generale has a strong market position in Europe, especially France, but also has a good presence in many developing markets including LATAM, Africa, Asia, and Eastern Europe.

Exceptional Profitability From Interest Rate Tailwind

With the ECB raising the cost of capital and rates on the marginal lending facility likely to edge towards 4 percentage points in 2023, Societe Generale is poised to see an enormous profitability tailwind. Personally, as compared to 2021 numbers, my model - which anchors on management commentary from Deutsche Bank, Barclays, UniCredit, and Societe Generale - calculates that for every 1 percentage point of interest rate increase, European banks are likely to enjoy a 20 basis point increase in NIM expansion. For Societe Generale's $1.5 trillion of assets, such a tailwind could likely add as much as $12 billion in incremental operating income by late 2024.

Investors should also consider that the interest rate tailwind will be complemented by operating discipline, as many European banks including Societe Generale have learned to work well in periods of low profitability/ low interest rates. Notably, the bank's cost-to-income ratio has fallen below 60.7% in the period from January to the end of September 2022, down from 66.9% in the same period for 2020.

Given the favorable environment, Societe Generale's profitability has already started to expand attractively. For the trailing 9 months (Q3 reference), the French bank has generated EUR 4.5 billion of net income, up 11.2% year-over-year. For reference, Societe Generale's current equity value is priced at approximately only double this estimate, at a market cap of close to $24 billion.

Valuation Makes Little Sense

In the context of rising interest rates and strong profitability, Societe Generale's valuation makes little sense, I argue. In fact, priced at x0.38 Price to Tangible Book, the French banking giant could perhaps be the most undervalued financial institution in Europe, if not globally. For reference, even Deutsche Bank is valued at x0.4 Price to Tangible Book. According to research by Goldman Sachs, x1 Tangible Book can be considered as the "recession valuation."

Residual Earnings Valuation

To get a more precise estimate of what Societe Generale could be worth, banks are prime candidates to be valued with a residual earnings valuation. The RE framework anchors on both the income statement and the balance sheet as well as accrual accounting. As per the CFA Institute :

Conceptually, residual income is net income less a charge (deduction) for common shareholders' opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company's capital.

I apply the following assumptions:

• To forecast EPS, I anchor on consensus analyst forecast as available on the Bloomberg Terminal 'till 2025. In my opinion, any estimate beyond 2025 is too speculative to include in a valuation framework - especially for banks.
• To estimate the cost of capital, I use the WACC framework. I model a three-year regression against the CAC 40 to find the stock's beta. For the risk-free rate, I used the 10y German Bund as of January 31, 2022. My calculation indicates a fair required return of 10.75%.
• For the terminal growth rate, I apply 2.25% percentage points, which is on the lower end of expected nominal GDP growth in order to reflect a conservative valuation.

Based on the above assumptions, my calculation returns a base-case target price for Societe Generale of $65.60/share, implying a material upside of close to 130%.

I understand that investors might have different assumptions with regards to Societe Generale's required return and terminal business growth. Thus, I also enclose a sensitivity table to test varying assumptions. For reference, red-cells imply an overvaluation as compared to the current market price, and green-cells imply an undervaluation.

Without a financial market meltdown, the picture looks very favorable to me.

Risks

In my opinion, bank investments are safer than perceived, but there remains an elevated tail risk, that could lead to Societe Generale approaching bankruptcy in extreme financial distress situations. The banking industry is still recovering from the financial crisis, and many big financial institutions have not yet regained pre-crisis levels. Despite this, Societe Generale's strong CET1 ratio of 13.1% should provide protection in the most challenging scenarios.

Conclusion

At x0.4 Price to Book, Société Générale Société anonyme's valuation makes little sense - especially considering the attractive interest rate environment. In fact, with the ECB raising the marginal lending facility likely to 4 percentage points by the end of 2023, Societe Generale is poised to see an enormous profitability tailwind that could add as much as EUR 12 million to Societe Generale's bottom line in 2025 as compared to 2021, according to my calculations. Personally, I base my valuation of Societe Generale stock on a residual earnings model and calculate a fair share price of $65.60.

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