Evaluating banking sector entities is “special” because the concept of assets and liabilities is

reversed and by extension, standard metrics (ratios) used to evaluate general stocks become
irrelevant here. In this article, we shall delve into how banks work and the process of valuing
banking sector stocks.
The focus in this document is on commercial banks, i.e. banks that derive a bulk of their
revenue from traditional banking methods i.e. through deposits and loans. To keep it simple,
these banks take deposit at an interest rate, say “x” and lends at a higher interest rate “y”. This
spread [y-x] is used to cover the overheads of the bank and contributes to the profit of the
bank.
From the above paragraph, it is clear that deposits and loans constitute the most important
sections of liabilities and assets section of the balance sheet. However, the breakdown of
asset section, in the order of decreasing liquidity are cash, reserves with central bank, money
at short notice (inter-bank lending), short and long-term investments, advances and fixed
assets. Similarly, the in decreasing order of liquidity- deposits, short & long-term borrowing
make up the liability section. Difference between them, of course would be the equity. Refer
to Exhibit 1 for an excerpt from HDFC Annual report reflecting its balance sheet.
Notice the change in the paragraph: Deposits are liabilities and Loans are assets.
Now that we know the basic components of a bank’s balance sheet, it’s time to focus on the
key ratios used in bank stock evaluation.
Key Ratios:
Credit assessment capabilities:
To assess the performance of a bank, or of any other institution such as an Insurance company
which promises to pay off on event of a mishap, the key would be understanding its
underwriting competency. In plain words, underwriting is the risk assessment process used
by bank while offering credit. If the company exercises discipline while underwriting, i.e.
understand the risk profile of the transaction; the institution is bound to perform better. A lot of
the problems witnessed today by the banks which hit the headlines of dailies such as high
NPAs, large haircuts, high provisioning are a consequence of poor underwriting capabilities
on the part of the banks. This leads to greater provisioning requirements by the banks to cover
up for their follies which gradually pulls down its assets. This facet of negligible lending which
plagues the balance sheet of both – the borrower and lender has been famously referred to
as the twin balance sheet syndrome in the Economic survey 2016.
A good proxy for under-writing competency would be Return on Equity (RoE). Though there
is no definitive level, a common thumb-rule is that a RoE greater than 10% for the last 5 years
would qualify as a good investment target. Needless to say, higher the RoE, better the find. A
risk averse investor may go as far as 10 years to check the record of the financial institution.
Another yardstick can be the asset to equity ratio. This ratio, essentially compares the loans
and advances the bank shells out as a ratio of its equity. Since loans are primarily the interest
earning assets for the bank, this ratio is expected to be high. Again, the industry benchmark
for this is approximately 10. A ratio well below 10 could mean that the bank is too conservative
in its approach and isn’t taking enough risks, hence doesn’t possess enough scope to earn
decent returns. Meanwhile, ratios well above 10 could mean that the company is giving out
loans far too often and easily, raising doubts on its underwriting competency.
The discussion about credit risk/ under-writing abilities would be incomplete without the
mention of the Gross NPA% which would demonstrate the quality of the bank’s loan book.
NPA or the bad loans are those assets whose interest is overdue more than 90 days hence
running a risk of default. The ratio of the NPAs to the total loan, in percentage terms is called
gross NPA percentage. Gross NPA ratio of ~1% should be sought after in a banking stock.
NPA ratios above 3% would be dicey and more than 5% would be straight NO!
Operational efficiency:
The measure of how efficiently the bank is running its operations would be the efficiency
ratio. It is basically the ratio of the bank’s operating expenses (excluding interest expenses)
to its revenue. An efficiency ratio of below 50% is characteristic of a good banking stock in
US. However, since the deposit rates in India is much higher than US, this ratio will be much
lower.
Efficiency ratio is however not much used in India, instead Net interest margin (NIM) is widely
quoted and used. NIM, in simple terms, is the difference between the interest earned (on
loans) and interest paid (on deposits) as a ratio of interest earnings assets. Greater NIM
reflects greater ability on the part of bank to generate income over the assets, therefore a
higher spread between the interest earned and interest paid. A higher NIM is a measure of
superior performance, a NIM of greater than 3% is desirable in a stock. Hence, a potential
investor would be interested in the trend of NIM to understand the ability of company to extract
value from its assets.
While mentioning NIM, CASA (current and savings account deposits) ratio cannot be
ignored since a CASA attempts to capture the overall cost of funding. CASA is the ratio of
current and savings deposits to total deposits. As term deposits (fixed deposits) command
higher interest rates in relation to CASA deposits, a higher proportion of CASA deposits would
essentially mean lower cost of funding and therefore a higher NIM. There’s no prescribed
ballpark figure to it. CASA ratios for few banks are shown in Exhibit 3.
Revenue and profit Growth:
This portion is like other industries, in terms of ensuring sustained growth in both the top line
and bottom line. The thumb-rule is that the financial institution must register a revenue and
PAT growth of at least 10% YoY for the past five years (conservative investors can look for
10 years data). This substantiates the fact the company continues to invest in interest earning
assets which translate into higher profits, higher EPS and higher dividends to shareholders
thereby fuelling the share price growth.
Price:
Banking more often than any other industry is more susceptible to intermittent panics, some
of which are a result of the factors discussed before have a direct impact on its revenue and
profits. These uncertainties in income, because of “adjustments” to operating profits -
provisioning for NPAs cause a lot of fluctuation in PAT and therefore the EPS. Hence, Price
to book ratio is a more relevant criterion than Price to earnings ratio for relative
comparison between peer banks. Due to its higher base, book value forms a more stable
and reliable metric for comparison between banks. By Book Value, we mean the tangible book
value exclusive of the goodwill which has no tangible benefit in earning income. A reputed
bank with a PB ratio of less than 2 would be a good pick. However, the value could go higher
if the bank is a well-known brand with high corporate governance standards and has
demonstrated good revenue and earnings growth.
Regulatory requirements:
On the back of financial crisis in 2008, regulators around the world tightened banking industry
norms. In addition to these national level restrictions, Basel committee issued new norms that
aimed to strengthen the bank’s capital requirements. Of these, one major ratio for commercial
banks is the capital adequacy ratio (CAR) which is the ratio of Bank’s Tier 1 and 2 capital to
its risk weighted assets (RWA).
The calculation of RWA helps in understanding the actual value of risky assets given the risk
profiling of every asset is carried out. Basel obligates the CAR value for the bank to be above
8; however as per RBI norms scheduled commercial banks are required to maintain this above
11.5 (including countercyclical buffer) (1). It is evident that all the operating banks shall have a
ratio above 11.5, a healthier ratio above 15 would be desirable and puts the banks in a better
shape to service the depositors and therefore more likely to see through the next financial
crisis. This value can be obtained from the bank’s annual report.

Recent trends and relevant parameters:

Given the recent PNB fiasco, which is essentially a case revolving around default on
contingent liabilities, this is one number the investors cannot turn a blind eye to. Contingent
liabilities (CL) are the off-balance sheet items, which the bank has exposure to and could
turn into future liabilities depending on outcome of specific events. Although most of these are
event-specific and have low probability of crystallizing, investors cannot ignore that in the
exceptional event of their materialisation there lies a risk of these liabilities eating up all the
bank’s asset base. Amongst all the CL, guarantees extended by bank will be the most critical.
A high Guarantee to Networth or Guarantee to asset ratio means exposure of bank to higher
systemic risk of default. Exhibit 2 gives out these ratios for leading PSU banks.
Two other parameters to watch out for is the recovery rate on NPA’s and Provision
coverage ratio(PCR). Recovery rates are defined as the percentage of the total exposure
recovered from a defaulting entity. Recovery rates signal future trends in the existing NPA
exposure of the bank. A high recovery rate will allow banks to write-back in significant sums
from the provisioned amounts, thereby boosting profitability in the future. PCR is a measure
of the quantum of the funds (mostly out of their profits) set aside by the banks to cover for their
bad loans. Provisioning is one of the most important regulatory mechanisms devised by the
RBI to tackle the lingering NPA problem. Although there’s no prescribed rate for it, RBI prefers
PCR to be close to the benchmark of 70%(2).

In a NUTSHELL:
1. Bank’s functionality: Understanding of bank’s business model and revenue streams.
2. Credit assessment capability:
a. ROE >10%(great stocks) over a period of not less than 5 years.
b. Asset to Equity ratio of around 10 (To be viewed in conjunction with ROE).
c. Gross NPA ratio of ~1%.
3. Operational efficiency:
a. Low Efficiency ratio (if available)
b. NIM > 3%
c. Higher CASA ratio.
4. Sales and profit growth:
a. Revenue and PAT growth >10%.
5. Price:
a. PB ratio – subjective based on company. PB < 2 is considered good.
6. Regulatory requirements and other parameters:
a. CAR ratio > 15
b. Low Guarantee/Net asset or Guarantee/networth ratio.
c. PCR close to 70%
Exhibit 1:
HDFC Balance Sheet (As at March 31, 2017):

Capital & Liabilites (In 000's)

Capital 51,25,091
Reserves and Surplus 8894,98,416
Deposits 64363,96,563
Borrowings 7402,88,666
Other Liabilities and provisions 5670,93,181
Total 86384,01,917
Assets
Cash and balances with RBI 3789,68,755
Balances with banks and money at call and short notice 1105,52,196
Investments 21446,33,366
Advances 55456,82,021
Fixed Assets 362,67,379
Other Assets 4222,98,200
Total 86384,01,917
Off-Balance sheet items:
Contingent Liabilities 81786,95,893
Bills for collection 3084,80,352

Ref. Balance sheet from HDFC Bank’s Annual report 2016-17 (BSE)

Exhibit 2:

Total
Company Networth(NW) Assets Guarantees(G) G/Assets G/NW
SBI 156700 2705966 202360 7.5% 129%
PNB 38096 720331 52109 7.2% 167%
BoB 36726 694875 25143 3.6% 68%
Canara 28312 583519 40297 6.9% 142%
BoI 25078 626309 41817 6.7% 167%

Values of Networth, Total Assets and Guarantees are quoted in crores and are updated as of
FY17
(1)
Courtesy: Moneycontrol article on Contingent liabilities
Exhibit 3:

Company CASA Ratio (as of FY18)

Kotak Mahindra 51.0%
HDFC 43.5%
PNB 43.9%
IDBI 37.0%
SBI 45.7%
Yes 42.0%
IndusInd 45.6%

Source: Company annual reports

Annexure 1:
Ratios of few banking companies:

Kotak
HDFC PNB IDBI SBI
Mahindra
Total Equity 50488.23 109080.11 42485.14 21907.96 219128
Assets 337720.47 1103186.17 778994.91 351136.78 3454752
A/E ratio 6.69 10.11 18.34 16.03 15.77

2018 6147.14 18560.84 -12584.33 -8157.11 -6547

2017 4949.08 15287.4 901.13 -5069.45 10484
2016 3431.12 12817.33 -3663.27 -3623.78 9951 PAT
2015 3065.08 10700.05 3341.42 957.26 13102
2014 2511.54 8764.51 3534.61 1166.2 10891

2018 50,488.23 109080.11 42485.14 21907.96 219128

2017 38492 91793.95 43164.86 23262.31 188286
Total
2016 33364.05 74304.12 41804.25 28058.44 144274
Equity
2015 22156.31 63154.07 42588.39 24374.9 128419
2014 19,084.53 43686.82 38516.33 23632.18 118283

2018 12.2% 17.0% -29.6% -37.2% -3.0%

2017 12.9% 16.7% 2.1% -21.8% 5.6%
2016 10.3% 17.2% -8.8% -12.9% 6.9% RoE
2015 13.8% 16.9% 7.8% 3.9% 10.2%
2014 13.2% 20.1% 9.2% 4.9% 9.2%

CAR 18.20% 14.82% 9.20% 10.41% 12.60%

Gross NPA 2.00% 1.30% 18.38% 27.95% 10.91%
Other
Net NPA 0.90% 0.40% 11.24% 16.69% 5.73%
ratios
NIM 4.30% 4.30% 2.16% 1.81% 2.60%
(FY18)
PCR 65.68% 69.78% 58.42% 63.40% 66.17%
CASA ratio 51.00% 43.50% 43.85% 37.00% 45.68%
Source: Company annual reports & Moneycontrol
Contributed by:
Venkat Samala,
PGP 2017-19,
IIM Bangalore
Mob.: 9738308313
Follow me on:
https://www.linkedin.com/in/venkat-samala-56066843/