Bank Stocks: A Short Guide on How To Analyze Stocks of Banks [Indian]

By Trader Pit

July 8, 2021


Banks (which are best classified as non-deposit taking financial institutions) have been a benchmark in the Indian stock market for years, with the S&P BSE Bank Index having been one of the best performing sectors during the past 5 years, since its inception in 2007. However, there is a lot of volatility in the sector, and as a result, we have seen the index change a lot over the last 5 years. As per the data we have collected, the Bank Sub-Components of the index have seen a range of returns in excess of 19% over the past 5 years.

Banks are a big part of Indian financial system. There are lot many banks in India. So, if you are interested in Banks, this article is for you.

How do you analyse bank shares? I have a stock analysis worksheet. It can analyze almost 90% of all stocks in the market. But it cannot analyze the actions of banks.

An analysis of banking company shares is not the same as an analysis of other companies’ shares. Why? This is because the business model of banks is different from that of other types of companies. As a result, their financial statements are also prepared differently.

Simply put, banks’ financial statements are different from those of other companies. Financial ratios that can be used for the analysis of other stocks are not effective for the analysis of bank stocks.

So if you want to analyze bank stocks, do that first. I recommend you read up on the business model of banks. This will help in quantitative analysis of bank shares.

Anyway, in this article I’m going to talk a bit about the bank before I talk about stock analysis.

Topics:

Bank

I will try to explain how bankers think about how to make money in their business. If we can understand how bankers think, we can better judge their actions. But let me warn you that what I am explaining here is a very simplified version of banking. In the real world, this is much harder to exploit.

#A. Direction of activity: Provision of lockers

Banks collect valuable assets from the public and keep them under lock and key. This is called a safe.

It is one of the activities that gave birth to the banking profession in the world. The luggage is delivered by the banks, isn’t it? Yes.

When it is time to retrieve the money/assets, all the bank has to do is go to the vault and return the money/assets to the depositor. That way, as long as the asset/money is in the safe, it is 100% safe. Read: That’s how you build a legacy.

But banks must charge a flat fee for keeping the money in the safe. Example: If you want to keep gold worth 5,000 rupees and cash worth 3,000 rupees in a safe, you may have to pay a fixed annual fee of 5,000 rupees.

As you can see, this is one of the most fundamental activities of banks. The bank will provide a secure storage area. In return, we pay them a fixed fee.

But this business has a very narrow profit margin. Why? Because the overhead costs are too high. In addition, customers have no incentive to open other safes except for the security of the deposit.

That’s why banks have found other ways to do business – more profitable ways. Example: Make savings accounts accessible to the public.

#B. Provision of services from accumulated deposits

Banks collect deposits from the public. Keep 20% of your money in a safe (read about the RRC and the SLR). Spend the rest of the money (80%) on making a profit for yourself.

So in this business model, the banks use some of our deposits to make their own money. The profits they make are in turn shared with us. How is the profit distributed? Provide income on our deposits in the form of interest (for example, 3.5% on a savings account).

Comment: Compare this to the safekeeping business model, where banks charge for our assets/money deposits – instead of paying income].

What happens to money deposited in a savings account? The money invested grows as it earns more interest. Suppose the amount of principal is Rs. 1.00.000. At an interest rate of 3.5% per annum, the deposit will have converted to Rs 103.5 trillion after one year.

It’s a win-win business model for everyone (the banks and us). How do you do that?

  • For people: First, they have a place to keep their money safe. Secondly, they have an incentive to keep their money in the banks as their deposits will also increase. How do you do that? Since the bank pays interest on deposits. Read: A guide to saving money.
  • For banks: Since banks receive money from people, they can use this money to further their activities and make a profit. This allows the banks to cover their operating costs. Moreover, the banks also make a profit. Related reading: Airport business model.

Depositors are happy and the banking industry is happy because it is making a profit.

Banks: Their growth and limitations

How can banks grow? Collecting more deposits from the public. Then set aside 20% of it – in the RRC and the LRS, and use the other 80% to lend to others. In this way they generate income and profit.

But there is a limit to the amount of deposits a bank should collect from the public. How is this limit determined?

Let’s take a hypothetical example. Suppose you have 10,000 rupees in your savings. They want to keep the money in the bank and earn interest. There are only two banks in your village. Bank A has an account for 50 villagers and Bank B has an account for 350 villagers.

Which bank will you choose? Most people will choose bank B, right? Why? For the depositor, his money will be safer in a larger bank.

As an investor, how will you quantify the size of the bank? One way to do this is to look at the number of account holders they have. However, a more effective way is to look at their net worth. Why?

With more net assets, banks can accept more deposits from the public. Thus, to grow, banks must focus on increasing their net assets. Let’s illustrate this with an example.

  • Net value of SBI = Rs 195,367 crore.
  • Net worth of Kotak Mahindra = Rs 42,900 million.

Both banks are leading banks in India. Does this mean that both can collect the same amount of deposit from the public? Technically, the answer is yes. But an investor should look at deposits with different eyes.

What are insoles? For a bank, a deposit is an obligation. Why? Because the bank has to give it back to the company – with interest. The more deposits there are, the riskier the bank becomes. What’s the solution?

Maintain a balance between its deposits and its net assets. How do I know that? By examining their financial ratios (especially the equity multiplier).

Financial ratios of banks

The bank must maintain a balance between growth and risk. Growth is a good thing, but it must not come at the expense of business risk.

Example: Yes, Bunk. He focused only on increasing his fortune. But she didn’t care about the quality of her investments. Thus, the company has accumulated a stack of NPAs so far.

How do you check if a bank’s operations are safe or if they are in a risky zone – like Yes Bank? Here are the following financial ratios we can look at for banks:

#1. Advance payment rate (ADR) and its growth rate

A bank with a low ADR (loan-to-deposit ratio) is considered safe. Consider the case of the State Bank of India. As a public bank, it must necessarily operate within secure boundaries. How should I know?

The first indicators can be seen in the infographic above:

  • A/D ratio : In the last five years of operation, the average A/D-SBI ratio was around 0.74. What does that mean? The Bank disburses only about 74% of the borrowed funds. This is what can make SBI a reliable bank. Compare that to Yes Bank, which lends more than it deposits (A/D ratio greater than 1). Other banks like HDFC Bank and Kotak Mahindra also have an A/D of less than 1. Therefore, Yes Bank is risky, while other banks are relatively safer. Read: What happens if the banks are cut off?
  • Growth rate : Here we compare the growth rates of Prepayments and Deposits. What are advances? These are loans made by the bank to the general public. If the growth in advances exceeds the growth in deposits, this indicates a higher risk. Except SBI, all banks have higher growth rate of advances than deposits, which makes them risky. But because Kotak and HDFC Bank keep their A/D ratio below 1, they are safe. But Yes Bank has both indicators as red flags. Read: About the weaknesses of the banking system.

Checking the A/D ratio is only a starting point. Further tests should be conducted. Why? You will find that an SBI that appears to be a more reliable bank in terms of A/D ratio falls apart on subsequent checks.

#2. Power multiplier (EM)

Before analyzing bank stocks, it is necessary to understand the concept and utility of capital multiples (CM). What is it?

The capital multiplier (CM) is the leverage available to the bank. What leverage is considered safe by banks? Number 15. What does that mean? Read: Debt is good or bad for business.

EM = total capital / net assets = 15 (maximum).

EM is the ratio of total capital to net assets. What is the total capital? It is the sum of the bank’s net assets and external debt. What is external debt? Example: deposits accepted by the public. Read: On return on capital employed (RoCE).

This rule of thumb allows investors to assess whether a bank is making its operations risky by taking too many deposits.

In the above screenshot, you can see that as far as the capital appreciation factor is concerned, only SBI gets a red flag. All other banks, including Yes Bank, are in the safe capital multiple of 15.

#3. Return on assets (ROA)

The concept of ROA should also be clear for the analysis of bank shares. What is return on assets (ROA)? In terms of the formula, the ROA is as follows:

ROA = net profit / balance sheet total

This is the profitability ratio. Why should investors use it for banks? It helps investors understand the extent to which total assets are used by the bank to generate profits. The higher the ROA, the better.

Unlike other business models, the banking sector generally has a lower return on capital. Why? Banking business is based on attracting deposits from the public. Deposits for banks are the same as debt for other companies. Other companies can survive without debt. But banks need debt to survive (read about it).

Therefore, it is sufficient to compare the ROA between the two banks. Because the ROA of a bank seems pretty thin when you compare it to that of a consumer products company.

What can be seen from the above picture is the asset performance of different Indian banks. From these figures we can see that an efficient Indian bank like HDFC Bank earns only 1.69% ROA. Kotak Mahindra is followed by HDFC Bank with 1.56%.

Generally, an Indian bank will do better if its return on assets is 1% or more. Based on this rule, SBI gets another red flag.

#4. Return on equity (ROE)

Knowledge of return on equity is also a prerequisite for analyzing bank actions. What is return on equity (ROE)? In the formula, the ROE looks like the one shown below:

Return on equity = net income / net assets.

ROE is the profitability ratio. Why should investors use it for banks? This helps investors understand how effectively banks use shareholder money to make a profit. The higher the return on equity, the greater the benefit to shareholders. Read: How to calculate return on equity.

As a general rule, a return on equity of more than 15 % is regarded as acceptable for banks.

Why is a 15% return on equity a number to pay attention to? Because it is derived from the two formulas we just examined (see infographic above:

  • EM15: We have read here what the multiplier of capital is. For a bank to operate at an appropriate risk level, the capital multiplication factor should not exceed 15.
  • ROA1% : We also read about the ROA of banks here. Based on historical data, it has been found that banks do not earn as high a return as other companies. But a reasonable return for a bank is at least 1%.
  • EWN15 : I call it the ROE15 rule. It is derived from the EM15 and ROA1% rule. If the bank meets the ROE15 requirements, it also meets the MA and ROA requirements. We will use this rule later in this article to learn how to analyze bank stocks.

We are now ready for a more complete analysis of bank stocks.

How to analyze bank stocks: Steps

The analysis of bank shares starts with (a) knowledge of the business model of banks and (b) knowledge of the concepts of ME, ROA and ROE. Once someone is done with that, they can move on to the next steps in stock analysis:

  • First step. Collect the data. This is necessary to collect financial data from banks. This data can be obtained from websites such as business-standard, economic times, moneycontrol, etc. What kind of data should be collected? NW, TA, PAT, interest income and interest expense. What do we do with this data? Use it to calculate EM, ROA, ROE and NIM. See here for information on the ROA and ROE of major banks.
  • Step Two: Check rule ROE15. Compare stocks with ideal values? What values? Next: EM: 15 (maximum). ROA: 1% (minus). Return on equity: 15% (minus). The most important thing is to control the ROE. EM and ROA will deviate from their ideal values. But their product (EM x ROA) should not go below 15. When bank stocks fail to meet the ROE15 rule, that’s a red flag. Investors should not ignore them in their investments. To see the return on equity of the major banks, click here.
  • Step 3. Check the MIN. What’s BAT? Net interest margin. The formula is as follows: NIM = (interest income – interest expense) / total assets. The higher the MIN, the better, right? A higher net interest margin means higher interest income (PI) per unit of assets. So a bank with a higher NIM is better, right? Experts say no conclusions should be drawn at the NMI stage. Perform a NIM and ROA analysis. Here you will find information about the BATs of the major banks.

NIM vs. ROA analysis by bank

Which is more important to banks – higher cash flow or higher return on assets? Don’t bother answering. I suspect that even some of the bankers here don’t have the right answer. Why? Bankers may think that by increasing the NIM, the ROA will also increase. But that may not be true.

What should the banks do? Follow the rule of thumb: NIM (max.) – 4 %. ROA (minus) – 1%. Why should cash flow be limited to (at most) 4%? If banks focus solely on increasing cash flow to more than 4%, research suggests this will have a negative impact on asset returns.

Why is that? Because if banks only focus on increasing cash flow, they end up lending too much. By trying to lend more, the end result is an increase in NPAs (bad loans) – like Yes Bank, etc.

MIN and ROA trend monitoring

Note your bank’s cash flow and return on equity over the past 5 or 10 years. If the NIM rises and the ROA falls, this is the first sign of danger. If the return on assets has fallen below 1%, that is an alarming sign.

Example: The NIM and ROA of Kotak Mahindra Bank are presented below. The cash flow rate is high, above 3.5%, but remains within the 4% threshold. That’s a good song. But the return on assets is falling. Consequently, their net effect on the Bank’s basic data is neutral. For investors, returns should increase over time.

  • Step Five. Check the growth rate. Ideally, banks should make more profit per unit of assets (total invested capital). This makes the Bank’s work more efficient. How do you measure that? Use the ROA. What should we look for in the growth figures? Two things: (a) the growth of PAT and (b) the growth of total assets. Let’s illustrate this with an example.

Which of the following banks is the best?

ICICI, Axis and Yes Bank have shown negative PAT growth over the past five years. Therefore, we will exclude these 3 banks from the comparison. Only HDFC, Kotak and Bandhan Bank remain. What are these three banks for? Asset and TAP growth is positive. But which one is the best?

Recall that banks need to make more profit with the same amount of assets (total capital). It can also be interpreted this way: A bank needs to grow its PAT faster than its assets. This allows banks to increase their return on assets (ROA).

Therefore, according to this rule, Kotak Mahindra Bank is the best, followed by HDFC Bank. Bandhan Bank is a new bank, so its growth rate is higher. But this bank is actually too small compared to Kotak and HDFC.

P.Note: Higher asset growth relative to TAP growth ultimately leads to lower asset returns. This is what happens when banks get caught up in the NIM growth race and forget about ROA. So the next time a bank boasts about its PAT figures, compare them to the asset figures.

The ideal is to improve the return on investment. But even better is the combination of better asset performance and PAT growth over total asset growth.

Output

It is important for banks to collect more and more deposits. However, it should not exceed a leverage of 15 (read here). Commodity banks maintain a minimum return of 1% on their assets. It is also important for banks to guarantee a return on equity of more than 15% (rule of thumb).

Banks with rising cash flows and falling returns on equity are not a good sign for investors. A simple way to check this is as follows: a) TAP Growth Rate (TAPGR) – last 5 years, and b) Total Asset Growth Rate (TAGR) – last 5 years. The bank must demonstrate that the PATGR exceeds the AGR.

Frequently Asked Questions

How do you analyze bank stock?

Bank stocks are analyzed by looking at the following: -The company’s total assets -The company’s total liabilities -The company’s total equity -The company’s return on assets -The company’s return on equity -The company’s long-term debt to equity ratio -The company’s current ratio -The company’s profitability -The company’s book value per share -The company’s price to book value ratio -The company’s dividend yield -The company’s price to sales ratio -The company’s price to earnings ratio -The company’s price to earnings growth ratio -The company’s price to sales growth ratio -The company’s dividend yield growth rate -The company’s dividend payout ratio -The company’s dividend payout ratio growth rate -The company’s dividend payout growth rate -The company’s return on equity growth rate -The company’s return on assets growth rate -The company’s long-term debt to equity growth rate -The company’s current ratio growth rate -The company’s price to book value growth rate -The company’s price to earnings growth rate -The company’s price to sales growth rate -The company’s price to book value growth rate -The company’s price to sales growth rate -The company’s price to earnings growth rate -The company’s price to sales growth rate -The company’s price to earnings growth rate -The company’s price to sales growth rate -The company

How do you analyze stocks in India?

Most stocks are analyzed by the company’s financials, such as its revenue, profit, and cash flow.

How do I choose a bank stock?

You can choose a bank stock by looking at its dividend yield, the price-to-earnings ratio, and the PEG ratio. A dividend yield is the percentage of the stock price that the company pays in dividends. A PEG ratio is the price-to-earnings ratio divided by the growth rate. A low PEG ratio means the stock price is relatively cheap. A high PEG ratio means the stock price is relatively expensive.

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About the author

Trader Pit

A yogi who like Finance and Technology. I have been in Indian Stock market for over 12 years now as financial analyst, portfolio manager, trader. Now, I focus on Yoga, Financial Education & Long term investing. 

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