What are the key metrics to track for banking stocks?

In this article I will summarize the key metrics that you should study in banking stocks before making an investment.

This is third in a series on understanding banking stocks. In the earlier articles I discussed how to read a bank’s balance sheet and also how you can read a bank’s income statement.

 

Net interest margin

You should look for high net interest margin. If not high already, there should be an increasing trend.

 

Increasing loan growth

Loan growth means more interest income but might not mean more net interest income. This is because a bank needs to garner enough deposits at a reasonable cost to back the loan growth. There are some banks which grow their deposits with wholesale deposits instead of lower cost current account, saving account deposits (CASA).

Analysts also look at credit to deposit ratios. In a nutshell, credit deposit ratios tell you whether credit / loan growth is sustainable. For a bank to make incremental loans, it also has to grow deposits.

 

Decreasing cost to income ratio

As operations become more efficient or loans outstanding per branch increase, operational costs decrease relative to income. Recall the profit and loss statement of a bank. Operational costs are deducted from net interest margin plus fee income.

 

Decreasing non performing assets

You can track non-performing assets on an absolute basis in Rs. cr or in percentage form (NPAs divided by advances) respectively.

Decreasing NPAs on absolute basis are always good to see. Gross NPAs less provisions give you net NPAs. It is not a good sign if net NPAs stay relatively static and gross NPAs increase. This implies higher provisions which reduce profit after tax.

In the short run, one might be misled by NPAs on a percentage basis because NPAs can stay the same or even grow on an absolute basis while advances may grow relatively more, yielding a lower percentage NPA number. An investor may feel that NPAs are under control while they are actually not.

 

High provisioning coverage ratio

I quote the RBI guidelines on provisioning, which define the provisioning coverage ratio.

Provisioning Coverage Ratio (PCR) is essentially the ratio of provisioning to gross non-performing assets and indicates the extent of funds a bank has kept aside to cover loan losses.

The RBI goes on to say how much the PCR should be.

From a macro-prudential perspective, banks should build up provisioning and capital buffers in good times i.e. when the profits are good, which can be used for absorbing losses in a downturn. This will enhance the soundness of individual banks, as also the stability of the financial sector. It was, therefore, decided that banks should augment their provisioning cushions consisting of specific provisions against NPAs as well as floating provisions, and ensure that their total provisioning coverage ratio, including floating provisions, is not less than 70 per cent. Accordingly, banks were advised to achieve this norm not later than end-September 2010.

 

What the RBI intends for the banks necessarily does not happen. Look at public sector undertaking banks (PSU Banks). Some of them have PCRs that are much lower than 70%. You will find PCRs around 50-55% too.

If they were to actually carry out provisioning as per the RBI circular they would see a dip in profit after tax. The RBI does not say anything presumably because most of the PSU banks are in a bad shape.

 

Prioritize the study of bank stock drivers

For me, the most important drivers of bank stock valuation are the non-performing assets. This is because, as I explained in the earlier article on bank balance sheets, banks are highly leveraged. What look like relatively low loss numbers on loans translate into high losses to the book value or net worth of a bank.

Reductions to book value mean a lower capital adequacy ratio. Lower capital adequacy ratio reduces the ability to lend. The only way out is to raise funds through diluting equity. Same earnings over higher number of equity shares lead to diluted earnings per share which has an impact on stock price.

That is why you should first concentrate on the NPA figures for a bank.

Pay attention to provisioning coverage ratios to check whether profit after tax is overstated.

If NPAs are under control, you can proceed to look at other metrics like credit to deposit ratios, cost to income ratios and percentage of CASA deposits.

 

Return on equity and return on assets

Finally, look at return on equity. There are few banks which are able to maintain a return on equity above 14-15%. If you consider your hurdle rate of investment to be 15%, the bank should at least be making 15% RoE. Alternatively, the trajectory of earnings and costs should be such that you will have increasing RoEs in the years ahead.

RoE can be magnified by excess leverage. Some PSU banks are highly leveraged even by banking standards, as compared to private sector banks.

Return on assets is good indicator if you want to dig deeper. You will find many banks in the 1%-1.2% range. J&K Bank and HDFC Bank for example are two banks with relatively high return on assets (1.7% and 1.9% respectively).

 

To be continued – how to value a bank stock

In the next article, I will discuss the various methods of bank stock valuation.

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Comments

  1. Rajesh Ranjan says

    Thanks for writing such a nice and informative articles on banks. However, I found headline of this artilce misleading. All things that you have discussed NIM, ROE, ROA, loan growth, cost to income ratio, etc are metrics to measure performanc of the bank; these are not in any way business driver of the banks. In my view, business driver of the banks would be the reasons behind say loan/deposit growth, reasons behind good or bad asset quality, etc.

  2. Rohit says

    Hi Kunal,
    Learned a lot from your website. Eagerly waiting for the next article on valuation of banks!

  3. avinash Bhupali says

    Kunalji
    Nice work done by starting screener in which I always use.similarly exellent article on analysing banking stocks.great social work for investing community.
    Avinash Bhupali

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