Indian Non-Banking Financial Companies (NBFCs) are entering a period requiring increased investor discernment, as the sector’s historical earnings premium over traditional banks begins to narrow. While still exhibiting robust growth, valuations are approaching long-term averages, and competitive pressures are mounting, particularly with the emergence of digital lending platforms.
According to Viral Shah, from IIFL Capital, a shift in investment strategy is warranted. “Incrementally over the past couple of quarters, we have been recommending to clients that NBFCs now is the time to be a bit more selective,” Shah stated. His assessment centers on three key factors: current valuations, a diminishing earnings advantage compared to both public sector and private banks, and the potential for margin compression.
Valuations and Earnings Premium in Focus
NBFC valuations are currently aligned with their long-term averages, and in some cases, are trading at a premium, justified by superior earnings growth. However, Shah anticipates that this earnings premium relative to banks will decrease as banks, including Public Sector Units (PSUs), experience an inflection point in their own earnings growth. Larger NBFCs are still projected to achieve a Compound Annual Growth Rate (CAGR) of around 25% over the next two years, but the gap is closing.
Margin risk is a significant concern. Despite a 125 basis point reduction in interest rates, yields on NBFC paper rated below AAA have remained stagnant for the past year and a half. This differentiation extends even within AAA-rated and corporate-backed NBFCs, indicating a complex landscape where cost of funds isn’t uniformly decreasing.
Shah explained that while NBFCs have benefited from lower borrowing costs from banks, these gains are being offset by higher costs in the market. “Cost of fund reduction on back of the repo rate cuts may not come through, which can lead to earnings cuts for NBFCs,” he noted.
Digital Lending: A Gradual Disruption
The rise of digital lending is poised to reshape the NBFC landscape over the next three to five years. New entrants like Airtel and Jio are joining established players such as Bajaj Finance. While these new players possess advantages in digital distribution and access to liabilities, Shah believes their impact will be gradual.
“It took Jio Finance three years to reach a ₹20,000 crore loan book on the NBFC side,” Shah pointed out. “In the near to medium term, there is no material threat to larger players. Competitive intensity will increase, but larger or more diversified players have levers to offset digital competition. It’s a gradual scale-up and nothing to worry about immediately.”
Selectivity and Diversification as Key Strategies
Given these dynamics, Shah recommends a selective approach to NBFC investment, favoring those that are diversified and possess strong advantages on the liability side, such as strong parentage or high credit ratings. “They seem better placed and will deliver stabler earnings growth over a longer period of time,” he said.
Valuations, while currently supported by strong lending growth, may require rationalization as digital lending gains traction. However, even with some valuation compression, larger NBFCs delivering 20-25% earnings growth could still offer investors a respectable 18-20% CAGR return.
Market Patience and the Importance of Long-Term Fundamentals
Shah also emphasized the importance of market patience and a focus on long-term fundamentals. He noted that valuation resets are inevitable when earnings growth slows, but temporary setbacks can present opportunities for investors who recognize the underlying strength of a company. He cited Chola Finance as an example, noting that its stock price had been significantly below current levels a year prior, despite the company’s strong long-term prospects.
The broader economic context supports continued growth in India’s financial sector. Amundi’s research highlights India’s “great transformation,” driven by scaling domestic manufacturing, broadening consumption, improved infrastructure, and strategic trade relationships. Fiscal and tax reforms are also designed to incentivize formalization and boost demand, contributing to medium-term growth and fiscal transparency.
The Economic Survey 2025-26, as reported by IBEF, further underscores the positive economic trajectory, though specific details of the survey’s findings were not available. Analysis of wholesale lending portfolios of 14 large NBFCs, including private sector lending from REC and Power Finance Corporation, is currently underway, according to EY’s recent update.
As NBFCs navigate this evolving financial landscape, selectivity, digital readiness, and a steadfast focus on long-term earnings stability are emerging as the guiding principles for investors seeking to capitalize on India’s continued economic expansion.
