How to do Analysis of Banking Stocks?

Analysis of banking stocks is not like analysing stocks of other business. Why?

Because the business model of banks are different from others.

For an investor who is interested to analyse banking stocks, it will be useful to first know the bank’s business model.

It will help in understanding the challenges faced by banks in comparison to other businesses.

Now, before going into the details of stock analysis, lets see how bankers think.

This will give us a useful insight about profit making in banking sector.

Thought #1. Keep money safe.

The thinking goes like this, Collect deposits from public. Keep all the money in locker.

When public comes to take back the deposited money, reach the locker and pay back.

This way, the depositors funds are 100% safe.

But to store money in locker, banks must charge a fees.

So this way, if a person deposits Rs.100 in bank, he will not get all Rs.100 back.

May be, the bank will deduct the fee (Rs.0.5 say), and return the balance Rs.99.5.

What does this mean?

  • The banks made a small income (0.5%).
  • But the depositors accept a loss of 0.5%, in exchange for safety.

This is not a very efficient banking business, right?

Hence banks do not operate like this.

Thought #2. Give return on deposits.

Collect deposits from public. Keep 25% money safe in locker (read about CRR & SLR).

Use the balance money (75%), to earn some profit.

So this way, a part of the earned profit can be shared with the depositors as well.

When the depositor comes to take his money back, what he gets are the following:

  1. The principal amount (say Rs.100 in savings account).
  2. Plus, Interest @3.5% as profit sharing (Rs.3.5).

This is a win-win situation. How?

  • Depositors gets back more than his original deposit.
  • Banks are also able to cover their cost of operation.
  • Moreover, bank is also able to make some profit.

Depositor is happy, and banking sector is also happy as they are making profits.

Thought #3. Grow the business.

Collect “as much deposit as possible” from public. Keep 25% money safe in locker.

Use the balance money (75%), to earn some profit.

But how much deposit a bank can collect?

Is it safe for banks to collect as much deposits as they want.

No. In order to grow the business, banks must grow their net worth first.

Lets understand this with an example.

  • SBI’s Net Worth = Rs.1,94,280 Crore.
  • Kotak Mahindra’s Net Worth = Rs.37,484

Both these are India’s top banks.

So does it means that both can collect the same amount of deposit from public?

Technically speaking, the answer is Yes.

But an investor must see “the deposits” from a different eye.

Deposits are a liability for banks. They have to pay it back to public.

So the more are the deposits, the riskier it gets for its investors.

So banks must maintain a safe “financial leverage” to keep its investors ‘worry free”.

What is financial leverage (Equity Multiplier)?

What financial leverage is said to be safe? Number 15.

What does it mean?

Total Capital / Net Worth = 15 (max).

This ratio is called Equity Multiplier (EM).

Total Capital = Net Worth + External Debt.

What is external debt? Example: deposits accepted from public.

Investors can use this rule of thumb to estimate, how much deposit, SBI and Kotak can accept from public.

  • SBI
    • Net Worth = Rs.1,94,280 Crore.
    • Equity Multiplier (EM) = 15 (max).
    • Total Capital (max) = Rs.29,14,209 Crore. (15 x 194280).
    • External Debt (max) = Rs.27,19,928 Crore (Capital minus net worth).

So a bank like SBI, whose net worth is Rs.1,94,280, can avail max debt of Rs.27,19,928 crore.

If it is having more debt, it means its business is risky. Investors must consider SBI with caution.

  • Kotak Mahindra Bank
    • Net Worth = Rs.37,484 Crore.
    • Equity Multiplier (EM) = 15 (max).
    • Total Capital (max) = Rs.5,62,257 Crore. (15 x 37484).
    • External Debt (max) = Rs.5,24,773 Crore (Capital minus net worth).

So a bank like Kotak, whose net worth is Rs.37,484, can avail max debt of Rs.5,24,773 crore.

If it is having more debt, it means its business is risky. Investors must consider Kotak with caution.

The concept & utility of Equity Multiplier (EM) must be clear before analysing banking stocks.

Return on Asset (ROA)

The concept of ROA must also be clear to analyse banking stocks.

What is Return on Asset (ROA)?

In terms of Formula, ROA is as below:

ROA = Net Profit / Total Assets

It is a profitability ratio. Why investors must use it for banks?

It helps investors to understand, how well the total assets are used by banks to generate profits.

The higher is the ROA, the better.

Unlike other business models, banking business typically show lower ROA.

[P.Note: It is necessary to compare ROA between banks only].

Return on Equity (ROE)

Knowledge of ROE is a must to analyse banking stocks.

What is Return on Equity (ROE)?

In terms of Formula, ROE is as below:

ROE = Net Profit / Net Worth.

Net worth is also called shareholders fund.

It is a profitability ratio. Why investors must use it for banks?

It helps investors to understand, how well the shareholders funds are used by banks to generate profits.

The higher is the ROE, it means, shareholders are benefitted more.

As a rule of thumb, ROE >15% for banks is considered acceptable. 

How to do Analysis of Banking Stocks_1So now we know 3 things about banking stocks:

  • EM must be less than 15.
  • ROA must be more than 1%.
  • ROE must be more than 15%.

Now we are ready for a more comprehensive analysis of banking stocks.

How to do Analysis of Banking Stocks?

Analysis of banking stocks begins with the following:

Once a person is done with this, follow the below steps.

Step #1. Collect Data

It essential to collect financial data of banks.

One can get this data from websites like business-standard, economic times, moneycontrol etc.

Which data to collect? What to do with this data?

Collect Data:

  • Net Worth (Last 5 Years).
  • Total Asset (Last 5 Years).
  • Net Profit (Last 5 Years).
  • Interest Income (Last 5Y).
  • Interest Paid (Last 5Y).

Calculate:

  • EM (Equity Multiplier).
  • ROA (Return on Assets).
  • ROE (Return on Equity).
  • NIM (Net Interest Margin).

A similar data collection for the following 5 banks led to this result:

SLNameEMROAROE
1HDFC Bank10.51.717.85
2SBI16.30.376.03
3Kotak7.51.5311.48
4ICICI Bank8.081.512.12
5Axis Bank10.391.0811.22

Step #2. Check ROE15 Rule

Compare stocks with the ideal values? Which values? Following:

  • EM : 15 (max).
  • ROA : 1% (min).
  • ROE : 15% (min).

The most important is to check the ROE.

EM and ROA will vary from their ideal values.

But their product (EM x ROA) must not go below 15%.

What is their product?

EM x ROA = ROE

In the above collected data you can see the following:

  • HDFC Bank – ROE is above 15%.
  • SBI – ROE is too low @6%.
  • Kotak – ROE is below 15% @11.48%.
  • ICICI – ROE is below 15% @12.12%.
  • Axis – ROE is below 15% @11.22@.

If banking stocks are not following the ROE15 Rule, it is a bad sign.

Investors must not ignore it while investing.

Step #3. Check NIM.

What is NIM? Net Interest Margin.

NIM = (Interest Profit) / Total Assets
NIM = (Interest Earned – Interest Expended) / Total Assets.

From the above formula, it is evident that, the higher is the NIM the better, right?

Because higher NIM means, more “interest profit (IP)” per dollar asset.

Lets try to understand this phenomenon with an example.

Suppose there are two banks:

  • Bank A
    • Accepts 100 nos deposits. Pays 5% interest on it.
    • Gives 100 nos loans. Charges 7.5% Interest on it.
    • Total Asset = Rs.X Crore
  • Bank B
    • Accepts 100 nos deposits. Pays 5% interest on it.
    • Gives 100 nos loans. Charges 8.5% Interest on it.
    • Total Asset = Rs.X Crore

So what do you think, which bank will have a higher “Interest Profit (IP)”?

Bank B will have a higher IP as its interest on loans are higher.

So as an investor, how we can conclude?

  • IP is high.
  • We will calculate the NIM
  • If NIM is high, bank is good.

Higher NIM Bank is better, right? Not so fast…read more….

Lets take a real life example:

(Mar’18)Kotak Mahindra BankICICI Bank
Net Interest Margin (NIM) %3.592.81

From the above, which bank looks better?

Kotak Mahindra Bank is better as its NIM is higher, right?

But experts says that one must not conclude at NIM stage itself.

There must be one more step. What is it? Read step #4.

Step #4. Check NIM vs ROA.

This could be a little complicated to understand. Hence I will start with a question?

Which is more important for banks:

  • To have a higher NIM? or
  • To have a higher ROA?

Do not bother to answer. I suppose, even some bankers may not give a right answer here.

What is a confusion?

Bankers may think that by increasing NIM, ROA will also increase.

But this is not the case.

So ideally what banks must do? Follow a Rule of Thumb:

  • NIM (max) – 3%.
  • ROA (min) – 1%.

What is the peculiarity of 3% NIM?

If banks, will focus only on increasing NIM, at levels above 3%, research proves that it negatively effects ROA.

Means, a bank which has NIM above 3%, will see a decline in ROA.

Why this happens?

Because when banks focus only on increasing NIM, they end up issuing too many loans.

In an attempt to disburse more loans, the end effect is more NPA’s (bad loans).

Bad loans means, loans are given to public/business who cannot pay back EMI’s.

What can be done?

  • Focus less on NIM.
  • See NIM under ROA’s lens.

How to do it?

Check NIM and ROA trends of the bank.

Note down last 10 years, NIM and ROA of your bank.

If NIM is going up and ROA is coming down, it is the first sign of danger.

If ROA has fallen below 1%, means danger is looming large.

Example: NIM and ROA of Kotak Mahindra Bank.

  • NIM is showing a decreasing trend in last 10 years.
  • ROA has an increasing trend in last 10 years.

How to do Analysis of Banking Stocks_3

Step #5. Check Growth Rates.

Ideally, banks must produce more profit for the same asset site (total capital).

This makes the bank more efficient.

How to measure it? use ROA.

ROA = Net Profit / Total Assets.

But when we see the numbers published by companies, we focus on what?

  • Revenue growth.
  • Net Profit Growth.
  • Net worth Growth.
  • Total Asset Growth etc.

But my suggestion is to narrow the search and look for things more useful for investors.

What one must look for? 2 things:

  1. PAT Growth.
  2. Total Asset Growth.

Example:

Out of the below listed banks, which is better?

Asset Growth Rate (5Y)Net Profit Growth Rate (5Y)
HDFC Bank16.70%15.58%
SBI13.86%-190.32%
Kotak Mahindra Bank24.78%22.14%
ICICI Bank7.45%3.32%
Axis Bank12.52%-46.38%

SBI and Axis Bank has shown negative PAT growth in last 5 years. Hence remove these 2 banks from comparison.

What is left is HDFC Bank, Kotak & ICICI Bank.

If we rank these 3 banks in terms of their growth rates, it will look like this:

  • #1 Rank – Kotak > Asset Growth @24.78%, PAT Growth @22.14%.
  • #2 Rank – HDFC > Asset Growth @16.78%, PAT Growth @15.58%.
  • #3 Rank – ICICI > Asset Growth @7.45%, PAT Growth @3.32%.

So does it mean that Kotak is the best bank and HDFC is second?

For investors, none of the above banks are showing good fundamentals. Why?

Remember, banks must produce more profit for the same asset site (total capital).

What does it mean?

It means, PAT growth must always be more than Asset growth.

Though the above 3 banks are showing positive growth rates, but their PAT growth rate was smaller than Asset Growth rate.

Higher Asset Growth rate (compared to PAT growth) ultimately translates into falling ROA.

This is not good for banks.

When this happens?

This happens, whenever banks get into the rate race of NIM growth, forgetting about ROA.

So next time, whenever any banks boasts their PAT numbers, compare it with Asset.

Which Banks in India has PAT Growth more than their Asset Growth?

How to do Analysis of Banking Stocks_4

To Sum up…

It is essential for banks to collect more and more deposits.

But it must not cross the financial leverage of 15 (see thought #3).

Goods Banks maintain a minimum ROA of 1%.

It is also important for banks to ensure ROE above 15% (rule of thumb).

Banks whose NIM is growing, but ROA is decreasing is not a good sign for investors.

One easy check is to look at the following:

  • PAT Growth Rate (PATGR) – last 5 years.
  • Total Asset Growth Rate (AGR) – last 5 years.

A bank must exhibit, PATGR more than AGR

2 Comments

  1. Very nice blog. Although you haven’t mentioned which method should be used to find intrinsic value of banking stock. As you have mentioned Bank has a different business model compared to other companies so does using same model like DCF will work to find intrinsic value of a bank stock?

    • Yes I am sure, DCF should work for banking stocks as well. Trick is to estimate the free cash flow of banking stocks accurately.

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