How to analyse Banking Stock?

 How to Analyse Banking stock

The banking business is different than the other business. Banks are acting as a mediator. Hence its stock analysis cannot be carried out like other stocks. In this article, I will try to elaborate on the ways of analyzing bank stocks. But before starting the analysis directly let us understand

 How banking business works?

Banking Business Module

What is the objective of normal investor keeping their money in the bank?

Ideally speaking Bank should charge us on keeping our money in a bank because the bank is protecting our money and providing a service of safety and security.

But this does not happen? Instead, we are expecting that bank should protect our money as well as give some returns to us.

If we keep out the money in a savings account we will get 4% interest and if we keep in FD we will get around 6 to 7%.

How Bank gives us a return on our money?

Bank act like a mediator. It gives the interest to the depositor and Bank dispenses some part of this money as a loan or it is also called advances with charging some interest and thus generates income. This is their main source of revenue or income generation.

Why Bank cannot dispense all deposited money? And how much it can dispense deposited money?

Ans: For example, if we keep 100 Rs.  In bank.

·         Out of these 100 rupees bank has to keep 4 rupees in RBI against the cash reserve ratio.(CRR) without any interest.

·         Out of 100 19.5 rupees bank has to keep in Government bond as per SLR (Statutory liquid ratio) rule of RBI. And government bond yield get changed periodically.

·         So a total of 23.5 rupees is in the safe zone and the remaining 76.5 rupees bank use for giving loans like car loans, home loans, personal loans, education loans, etc. And generates income for the bank and from this income, the bank gives us interest on saving account, fixed deposit, and any other products. The remaining balance from this money is bank profit.

Cost:

·         The interest is given to the retailer against deposit.

·         The bank operation activity also includes in cost.

Revenue:

·         The main source of the bank is interest earned against the loan (advances) distribution called as interest income.

·         Another source of income is the Distribution of multi products like a mutual fund, insurance, etc. and against it, the bank gets a commission.

·         Provision of services like lockers, and charges against the minimum amount and these are called as other income.

So from a bank point of view accepting deposits is a liability, interest income, and other incomes are revenue for the bank.

How to analyze Banking stock?

1.       Financial Leverage or Equity Multiplier

EM (Net worth factor) = Total Capital/Net worth. (And it should not go beyond 15)

Banking is a capital intensive sector. Bank cannot collect money as per his desire because deposits are the liability to the bank and it will be a risk to the bank because the bank has to pay interest to the depositor (Money is going out from the bank).

There are some rules to accept deposits. For that one should understand the net worth concept.

To analyze the banking stock net worth is an important factor. Because the higher the numbers of net worth higher the deposit will be accepted. Normally net worth is very low in number but it has multiplier factor and that number is 15 (normal). It is called equity multiplier or financial leverage

For example, if any bank has a net worth is 100 Rs and multiplier factor let us say 15 then the bank can accept deposit up to 1500 Rupees.

The formula for net worth factor (EM) = Total Capital/Net worth. And it should not go beyond 15.

There are multiple ways to calculate these ratios.

Total capital or Asset are used interchangeably linked it is called total capital or total asset.

Bank Net Worth = Difference between Total Assets and Liability

Financial Leverage or equity Multiplier (EM) = Total Assets/Net worth

Total Assets or Capital = Net worth + External Debt

External Debt = Total Capital –Net worth (public deposit)

2.       Return on Assets ROA.

ROA =Net Profit/Total Assets

Investors are keeping their money in the bank because they have faith in banks that bank will protect their money as well will give expected returns. But the investor must check the ROA of the bank. ROA is a profitability ratio.

Return on assets, ROA tells us how the bank utilizes its assets to generate the profit. These ratios are to be compared with other banking stock and the bank which has a higher return than the bank is not risky to keep their deposits in that bank because of low risk.

Normally ROA for the bank always remains on the lower side as per its business criteria (It accepts deposit from the investor which is debt for the banks.) Comparing the same thing i.e. debt for other industries then debt-free company can survive.) But to run the banking business bank has to accept deposits. Hence normal investor should compare the ROA of the other banks before investing in banks.

Ideally, it should be >=1%.

3.       Return on Equity ROE (> 15%)

ROE = Net Profit/Shareholder’s equity &

The other way of calculation is

=Equity Multiplier* Return on Assets

ROE is also a profitable ratio. It gives confidence to the shareholders for investment. Higher the ROE higher will be yield. ROE number states the utilization of shareholder funds and earns more profits which will be benefited to the shareholders.

The ROE should be > 15% why?

As stated above the ROE is also a multiplication of EM and RA. And

Ideally EM should be > 15% and ROA should be >1% and if we multiply theses figure it will come to 15%. Hence ideally ROE should be 15%.

4.       NIM(Net Interest Margin)

NIM= (Interest Earned-Interest Expended)/Total Asset

NIM is also an important ratio to analyze as the whole banking business relies on the margin between Interest earned (From dispensing money as an advance or loan)  and interest expended( Interest given to depositor).

NIM and Return on Assets are inversely proportional to each other

To improve the NIM to earn more profit if bank started concentrating on dispensing loan then there will be probability of generating high NPA because of non-returning the loan amount by the borrowers (Bad loan).

Hence the bank has to make a balance between NIM and ROA. As per expert opinion, NIM should be a maximum of 3%.

5.       A-D Ratio (Advance Deposit ratio).

Advance (Loan) to Deposit should be below 1 as if it is above 1 that means Bank is dispensing more loan than deposit hence it will be risky for the investor. Because there will be a liquidation problem in the future. Hence it must be checked before investing in bank stock.

6.       Capital Adequacy ratio:

It is the amount of money that remained after disbursing the loan. It is a ration of assets to the loan disbursed. High CAR indicates that the bank has adequate money to disburse for advances or loans. From an investor point of view, it is safe for them. The higher the CAR is higher the potential of growth. Normally 12% of CAR is a safe zone for depositor’s money.

CAR can be improved if CASA (Current Account and savings account) the ratio is high because for current account bank does not pay any interest and for a savings account, it pays around 3-5% only hence there will be a higher margin to earn more interest by disbursing the loan. 

 

Qualitative Factors:

·         Deposit should be granular and well diversified  (in order to maintain the stability number of depositors should be high)

·         Advances or disbarment should well-diversified and granular. The loan should be disbursed to cross-segment area mean loan should not be given to one sector only like Agriculture or manufacturing or auto etc. As this may result in a probability of high NPA.

 

Let us understand by example.

Below table data is of March-20 (The financial year 2019-20). I have retrieved all data from moneycontrol.com.

From the above table, you can observe that HDFC bank is performing well from all factors compare to other banks.

Though Bandhan Bank seems to be attractive next to HDFC, its A/D ratio is more than 1%. It means it is lending more money than deposits which is risky for the investor from a liquidity point of view. As higher the lending amount may lead to the probability of high NPA in the future.

The same thing was happened earlier with Yes bank.

Before coming to any conclusion please check all the data trends for at least five years. Here I have elaborated as an example.