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How to Evaluate Banking Stocks? – Part II

Economic moats in banking Stocks


One of the biggest deterrents that prevent more players from entering the banking industry is the tough regulatory requirements that all banks are supposed to comply with. In India, in any case, bank licenses are given out by RBI only from time to time and after much due diligence.

 

Banking is also a capital-intensive business; hence not too many players can enter it.

 

Economies of scale also give greater muscle to a bank. A State Bank of India (SBI) or a Citibank (internationally) enjoys scale-based advantages that are difficult for smaller players to match.

 

A large branch network, as mentioned earlier, is another key advantage. Punjab National Bank's (PNB) large branch network in north and central India gives it access to low-cost deposits that is hard for smaller players to match.

 

Going by the numbers


Capital base. In case of Indian banks, check their credit to deposit ratio (CDR). This ratio indicates the funds lent out of the total amount raised through deposits. A higher ratio indicates more optimal utilisation of funds. Check the bank's CDR vis-à-vis the industry range.

 

Next, look at a bank's capital adequacy ratio (CAR). The RBI has stipulated that the minimum capital adequacy ratio should be 10. This ratio ensures that banks do not expand their business without having an adequate buffer of capital.

 

            Tier I capital + Tier II capital
CAR = ---------------------------------
            Risk-weighted assets

 

Keep an eye on the reserve provisions made for bad loans relative to non-performing assets (NPAs). Net NPA ratio is a measure of the overall quality of the bank's loan book. A higher ratio reflects rising incidence of bad loans.

 

                                Net non-performing assets
Net NPA ratio = ---------------------------------
                                Loans given

 

Profitability. Return on equity (RoE) and Return on Assets (RoA) are the standard metrics for checking a bank's profitability.

A red flag should go up in your mind if a bank's RoE or RoA shows excessive deviation from that of its peer set. It is easy for a bank to boost its earnings in the short term by under provisioning for bad loans or by leveraging the balance sheet. This increases the risk over the long term. The recent financial crisis in the US is an example of all that can go wrong when excess leverage is employed by financial institutions.

 

             Net profits
ROA = ---------------
             Avg. total assets

 

Efficiency ratio. Check the operating profit margin of the bank you are evaluating. If a bank is able to keep its expenses under check, that is a positive sign.

Operating profit for banks is calculated after deducting administrative expenses (which include salary cost and network expansion cost) from its net interest income.

 

             Net interest income (NII) - operating expenses
OPM = ---------------------------------------------
             Total interest income

 

Controlling overheads is critical. This can be done through branch rationalisation and technology upgradation. The cost to income ratio indicates how good a job a bank is doing at controlling costs:

                                               Operating expenses
Cost to income ratio = ---------------------------
                                               NII + non interest income

 

Net interest margin. Net interest margin (NIM) is the net interest income as a percentage of average earning assets. It shows how profitable a bank's lending and deposit-taking activities are. Keep a tab on the long-term trend in a bank's NIM.

 

             Interest income - Interest expenses
NIM = ------------------------
             Average earning assets

 

Price-to-book. This is the key measure of valuation for banking stocks. Compare the bank's current P/B with its historical P/B levels (say median for past three years). Also compare it with that of its peers. This will tell you how expensive its valuation is.

 


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