How to Analyze Bank Stocks ?
Banking stocks are completely different breed of stocks because of their business model. Analyzing banking stocks requires looking at completely different set of ratios. In this post of how to analyze bank stocks, we will learn about the numbers and ratios that you should look at while analyzing banking stocks.
Before we jump in to understand on how to analyze bank stocks, we need to understand the business model of banks and how they make money.
The business model of banks is simple, people deposit money with banks to keep it safe and earn interest, the banks in turn, lends it to the borrower at a higher interest rate.
The difference between interest earned from its borrowers versus what the bank has to pay to its depositors is called “interest spread”
For example, if a someone deposits Rs. 100 and bank promises to give 5% interest, the banks can lend this money to someone at a higher interest rate, let’s say 9%.
The difference between what the bank receives from the borrower (that is 9%) versus what it has to pay to its depositor (5%) is the profit of the bank, called interest spread(9%-5%=4%).
So how to analyze bank stocks to make sure that you have chosen the right one? Well, there are five numbers that you need to look at while analyzing banking stocks:
- Net Worth
- Equity Multiplier
- Net Interest Margins
- Return on Assets
- Non Performing Assets
The first term on how to analyze bank stocks is Net Worth. Also known as the Shareholder’s Equity,
Net worth of a bank is a crucial number. Since banks have to make sure that depositor’s money remains safe, they cannot accept unlimited deposits and keep lending.
In order to be able to grow their deposit and lending capacity, banks have to increase their net worth, which can then be used with equity multiplier (we will discuss about it in the next point) to understand how much a bank can borrow as deposits.
The second term on how to analyze bank stocks is Equity Multiplier. Since every deposit accepted by the bank is a liability which the bank has to pay back to is depositors with interest, in order to keep depositors money safe, banks have to maintain a financial leverage which is also known as equity multiplier.
Equity Multiplier is calculated by dividing Total Capital of the bank by its Net Worth, where total capital is sum of Net Worth and External Debt.
The Formula for Total Capital is as follows:
Total Capital=Net Worth+External Debt
where external debt is the deposits accepted from public.
The Formula for Equity Multiplier is as Follows:
Total Capital/Net Worth
In terms of banking stocks, a safe financial leverage is 15, that is, if the Equity Multiplier number of a bank is under 15, it is considered to be safe.
Example: If a Bank has a Net Worth of Rs. 100 crores, the maximum deposit it can accept from public without taking too much risk is:
Which in this case is 100*15= 1,500 crores.
If the bank has more deposits than Rs. 1,500 crores, it should be considered as risky bet and investors must be cautious while investing in such banks.
Net Worth and Equity Multiplier are good way to understand how safe a bank is for investing.
However, safety of deposit is not the only priority of an investor.
In order to become an investment worthy bank, the bank has to grow its earnings, maintain healthy profit margins, use capital efficiently to maximize returns and be able to avoid risk of default.
To understand how well a bank is growing, you need to focus on three financial ratios:
- Net Interest Margins
- Return on Asset and
- Non Performing Asset
Net Interest Margins(NIM):
This is the third term on how to analyze bank stocks. As mentioned earlier, every bank accepts deposits from public at a promised interest rate and lends it to others at a higher interest rate.
The difference between these rates is the profit for the bank called interest spread.
Net Interest Margin is a number that shows how wide this interest spread is. Wider the margin, better it is for the bank. The formula for Net interest Margin is as follows:
Net Interest Margins = (Net interest Income-Interest Expenses)/Average Earning Assets
Higher Net Interest Margin shows that bank has efficiently allocated its resources, which shows that banks is able to accept deposits at lower interest rate from its public and is able to lend at a higher interest rate.
On the other hand, lower or negative interest margins show poor asset allocation and bank is incurring losses.
A high Net Interest Margin also acts as a cushion for the bank in tough times.
For instance, if the RBI(Reserve Bank of India, central bank, a body that regulates all the banks of the country) decides to cut lending rates, banks will have to provide loans to borrowers at lower interest rates (of course out of competition, as other banks will be lending at lower rates) which will lead to lower NIMs as the spread has narrowed.
In such situations, banks that were already working on lower Net Interest Margins may suffer a loss.
On the other hand, banks that have stronger NIM would still be able to stay profitable without much dent on their income.
Before we jump in to the next term on how to analyze bank stocks, I must tell you, Net Interest Margin should not be seen as the only profitability metric.
Investors looking to analyze banking stocks should also look at how efficiently the bank is able to allocate its assets to generate wealth.
Whether a bank is efficient in capital allocation or not can be understood by looking at its Return on Asset numbers.
Return on Asset:
Return on Asset(ROA) is considered as an important ratio to measure efficient utilization of capital. Since most of the assets of a bank largely consists of money, ROA indicates how much return a bank is earning on each rupee, making it a better measure of capital efficiency for a bank.
Return on Asset is calculated by dividing Net Income from total assets.
Since most of the banks are highly leveraged (that is instead of lending their own money, they borrow from depositors and lend it to the borrowers) an ROA of 1%-3% may represent substantial revenue and profit for a bank.
But why is it important to look at both ROA and NIM together? Let me explain this with the help of a simple example.
Example: Let’s say a bank has total assets of Rs. 1,500 crores, average earnings assets of Rs. 1,000 (500 crores of assets unused/idle) crores and is making Rs. 100 crores as Net income from lending and its interest expenses is 60 crores. So the NIM as per the formula will be:
(Net interest income-Interest Expenses)/Average Earning asset
And the total ROA of the bank will be:
ROA= Net Income/Total Asset
Now if more depositors start to deposit their money in the bank, and if bank is unable to find suitable borrowers for it, the deposits will lie idle, not generating cash flow for the bank, but bank still has to pay interest on it.
In such case bank’s interest expenses will rise while its interest income doesn’t, resulting in poor profitability or even a loss.
How does ROA play its role in this? Well, ROA shows how efficiently a bank is able to use depositor’s money and find borrowers for it.
Banks with high ROA demonstrate that bank is able to find borrowers for majority of the depositor’s money.
On the other hand, a declining ROA shows that bank is unable to allocate funds efficiently which may lead to higher interest expenses, lower income and ultimately, leading to losses to the bank.
Non Performing Asset:
The final term in our guide on how to analyze bank stocks. One of the most important ratio every investor must pay attention to is Non Performing Asset or NPA.
Not every loan provided by the banks gets repaid, some borrowers find themselves unable to pay back their loans, resulting in default.
When bank assumes that a part of loan provided by them will not be repaid, it is classified as NPA.
An NPA is recorded after 90 days of non payment of interest or principal by the borrower. There are three types of NPAs, substandard asset, doubtful asset and loss asset.
A substandard asset is one that has been non-performing for less than 12 months, a doubtful asset is one which has been non-performing for more than 12 months.
A loss asset is the one identified as default and must be fully written off as. A loss asset has no chance of being recovered.
So why is NPA important?
As mentioned earlier, NPA have to be written off from the balance sheet of bank by making sufficient provisions.
Making provisions reduces the total capital available to provide subsequent loans, which reduces the lending ability of the bank.
Once the actual losses are determined, they are written off against earnings.
If a bank has lot of NPAs it has to make provisions from its earnings in order to write them off from the balance sheet.
This significantly reduces the ability of bank to lend more in the future, adversely affecting their interest earnings and thus leads to lower profitability.
Every investor must look at the NPA trend of the bank for at least last 5 years in order to fully understand the situation.
Banks with lower NPAs are less risky, have better profitability and are supposed to be good candidate for long term investment.
Real Life Case Studies:
Having understood all the aspects of how to analyze bank stocks, it’s now time to put our learning to use and do some analysis and do some real life case studies.
In this section of how to analyze bank stocks, we will analyze two banks, one that has destroyed shareholders value in the past because of its poor management and other which has created shareholder value by managing assets well, and balancing risk rewards intelligently.
You can use these two examples as a case study to understand the characteristics of a good bank and how to analyze bank stocks and pick the right one for your portfolio.
First, we will look at the bank that have eroded the shareholders value in the last few years and how do they look like.
Punjab National Bank:
Punjab National Bank has been through tough times, with rising defaults and many cases of frauds and scams surfacing, stocks of PNB have been battered in the past few months.
But is PNB a good stock to invest in especially after being beaten down so badly? Let’s analyze PNB using what we have learned in this post.
Net Worth(Total Shareholders Equity): As per the latest annual result (March 2018) of PNB, the total Net worth of PNB stands at Rs. 41,074 crores, which is lower than previous year which was at Rs. 41,846 crores. This shows that PNB has lost shareholder value in the past 1 year, which is the first sign of deteriorating fundamentals.
Equity Multiplier: As mentioned earlier, Equity Multiplier helps us in understanding the borrowing ability of a bank and thus determine how safe or risky a bank is.
To understand how much deposit PNB can accept we need to multiply the Net worth of the bank with equity multiplier which is 15.
Net worth of PNB= Rs. 41,074 crores
Total Capital PNB can borrow= 15*41,074= Rs. 6,16,110.
The maximum deposit PNB can accept from public is Rs.6,16,110 crores. PNB currently has 6,42,226 crores of deposits which is much higher than the total borrowing capacity of the bank.
This makes PNB a risky bet as it has financial leverage higher than acceptable levels.
Net Interest Margins: The second factor we look at while analyzing a bank is it’s Net Interest Margins. If we look at the Net Interest Margins of PNB it has declined consistently which means that bank is losing its profitability.
The NIM of PNB in 2015 was 2.74% which declined to 1.94% in March 2018. Clearly PNB is not only heavily leveraged, but also losing its profitability every year.
Return on Assets: As I mentioned earlier, ROA shows how efficiently the bank is able to utilize its assets to generate more profit. In 2015, PNB had ROA of 0.5%, which is down to a negative (1.6%) in 2018.
PNB has negative ROA, which means company is incurring losses on the deposits, which is evident by looking at PNB’s profit and loss statement where bank has suffered loss of Rs. 12, 282 crores, largely contributed by provisions and contingent liabilities which increased from Rs. 8,893 crores in 2015, to Rs. 29,869 crores in 2018.
These provisions and liabilities are created as a result of large number of defaults from various entities leading to high NPA numbers.
Non Performing Assets: Final and the most important number for a bank is the Non performing assets which shows the amount of bad loans the bank may have to write off.
The NPA of PNB were around Rs. 15,396 crores in 2015, which rose to Rs. 48,684 crores in 2018.
If you look at the NPA percentage (NPA percentage Formula NPA%= total NPA/Loans given), the percentage has skyrocketed from 4% in 2015 to 11% in 2018, which means that bank assumes at least 11% of its total loans to become bad/loss loans.
Let’s sum up all the points we have learned by analyzing PNB:
- Decline in Net worth, Means bank is losing shareholder value
- Bank is highly leveraged (as per Equity Multiplier Formula)
- Bank’s Net Interest Margins have declined in the past years
- Bank’s ROA is negative meaning its losing money against its assets
- Bank has high NPA% which makes it a risky bet.
As a result of poor fundamentals, deteriorating asset quality, PNB stocks have destroyed shareholder value in the past years.
The second bank in our case study of how to analyze bank stocks is a bank that has created shareholder value by managing its assets efficiently and taking calculated risk.
We are going to analyze HDFC bank which is well managed, conservative, efficient in asset allocation and has created wealth for long term investors.
HDFC Bank is one of the largest privately owned bank, let us now see what were the characteristics that made HDFC bank such a great wealth creator.
Net Worth: HDFC Bank has been able to grow its Net Worth from Rs.61,508 crores in 2015 to Rs. 1,06,295 crores in 2018. The increase in Net Worth shows that bank is able to create wealth for itself and its shareholders, first sign of being a well managed bank.
Equity Multiplier: The second factor we are going to look at is if HDFC bank is the financial leverage, for which we will multiply the Net Worth of the Bank with Equity Multiplier and compare the number with the total deposits the bank has accepted from the public.
The Maximum capital HDFC Bank can borrow from depositors is 1,06,295*15=1,594,425 crores.
The total deposits HDFC bank has borrowed from public is Rs. 7,88,770 crores, which is well below the maximum limit. This shows that HDFC bank is conservatively financed and has not used excessive leverage to expand its business.
Net Interest Margins: Net Interest Margins(NIM) is a measure of profitability of a bank. Higher the NIM better it is for the bank.
HDFC bank has had very stable NIM ranging from 3.75% to 3.8% for the past 4 years. This shows that bank has been able to maintain its profitability by intelligently allocating assets with good quality borrowers.
Return on Asset: Return on Asset is a measure of how efficiently a bank has been able to allocate its assets in order to generate revenue.
HDFC bank has strong ROA, hovering around 1.7% to 1.65%, as mentioned earlier, since banks are highly leveraged, a small percentage of ROA shows huge revenue generation and profits.
Non Performing Asset: Finally, the most important number for a bank, is the NPA, denoting amount of loans a bank assumes will be bad and need to be written off balance sheet.
HDFC bank, unlike PNB, has stable NPA around 1% for the past 5 years, despite huge growth in loan book.
This is a very positive sign which shows that bank is able to keep its bad loans in check and is able to recover 99% of the loans given to the borrowers.
Let’s sum up the entire analysis of HDFC bank into few short points:
- Increasing Net worth, bank is creating shareholder value
- Bank has low financial leverage, meaning bank is safer investment
- High and stable NIM, shows it has kept its interest cost low while maintaining healthy interest spread
- Stable ROA, bank has been able to allocate its assets efficiently.
- Low NPA, most of bank’s loans are recovered, shows bank is lending to safe assets.
Clearly HDFC bank is not only a safer bet but has been a great wealth creator in the past the evidence of which can be seen in the stocks price trend of the bank.
That was all in our guide of how to analyze banking stocks, if you have any queries regarding how to analyze banking stocks, you can either comment below or email me at email@example.com
Thank You for reading, hope you find this useful, and knowledgeable.