Metrics for Evaluating Bank Stocks
- Banks come with their own specific issues, such as debt levels, a loan business, and reinvestment needs.
- Because banks have unique attributes, certain financial ratios provide useful insight, more so than other ratios. Common ratios to analyze banks include the price-to-earnings (P/E) ratio, the price-to-book (P/B) ratio, the efficiency ratio, the loan-to-deposit ratio, and capital ratios.
P/E and P/B Ratios
P/E ratios tend to be higher for banks that exhibit high expected growth, high payouts, and low risk. Similar tendency with P/B ratios.
- When utilizing ratios to compare banks, one has to compare banks of similar characteristics. Comparing a large investment bank to a savings and loan would not provide any insight as both are completely different types of entities with different goals, services, and customers.
The efficiency ratio is calculated as a bank's expenses (excluding interest expense) divided by the total revenue.
The main insight that the efficiency ratio provides is
- how well a bank utilizes its assets in generating revenue
- how well the bank's managers control their overhead (or "back office") expenses.
Efficiency ratios at 50% or below are considered ideal. If an efficiency ratio starts to go up, then it indicates that a bank's expenses are increasing in comparison to its revenues or that its revenues are decreasing in comparison to its expenses.
Loan-To-Deposit Ratio (or Credit-to-Deposit Ratio)
The loan-to-deposit ratio (LDR) is determined by comparing a bank's total loans to its total deposits.
The ratio indicates a bank's liquidity.
- If it is too high, the bank may be susceptible to a bank run due to rapid changes in its deposits, meaning it may not have enough funds to cover its requirements
- If the ratio is too low, it can indicate that a bank is not meeting its earning potential.
Capital Adequacy Ratio (CAR)
The capital adequacy ratio is calculated as a bank's capital divided by the risk-weighted assets. CAR are usually calculated for different types of capital (tier 1 capital, tier 2 capital) and are meant to assess a bank's vulnerability to sudden and unexpected increases in bad loans.
CAR is decided by central banks to prevent commercial banks from taking excess leverage.
Two types of capital are measured with CAR.
- Tier-1 capital allows bank to absorb a reasonable amount of loss without forcing the bank to cease its operations
- Tier 1 capital refers to the core capital held in a bank's reserves and is used to fund business activities for the bank's clients
- Under the Basel III accords, the value of a bank's Tier 1 capital must be larger than 6% of its risk-weighted assets.
- Tier-2 capital allows bank to sustain a loss if there's a liquidation
- Tier 2 capital is the second layer of capital that a bank must keep as part of its required reserves
- Tier 2 capital is subordinate to Tier 1 capital and is considered riskier as it is more difficult to calculate if a bank needs to liquidate it.
Net Interest Income
Net Interest Income (NII) is the difference between interest earned from a bank’s lending activities to its customers and the interest paid to account holders. This measure will give us a good idea about the principal business of the bank.
Net Interest Margin
Net Interest Margin (NIM) is calculated by dividing Net Interest Income to Interest bearing assets such as loans and advances. It is expressed in terms of percentage. This measure is be compared over the years to assess the business of the banks.
Return on Assets (ROA)
Return on Assets shows how profitable a bank is relative to its total assets. It also indicates how efficiently it is using its assets to generate earnings.
Return on Equity (ROE)
This ratio is used by the shareholders to measure their return on investment. ROE is calculated by dividing Net Profit by Net Worth (=Capital + Reserves & Surplus).
Total Advance is an important metric to look at because the bank’s primary earning comes from this asset.
Advances are loans given out to customers and hence it is considered as assets in the business and one of the key part of banking stock analysis. The rise in assets and rate of rising will tell us how the bank is growing its business.
Deposits form a major source of funds for the banks. Banks accept deposits in the form of term deposits, savings, and current accounts. Banks lend out of the deposits it receives. Hence, analyzing deposits numbers will tell us how comfortably the banks are able to acquire funds to lend.
CASA ratio of a bank is the ratio of deposits in current and savings accounts to total deposits. A higher CASA ratio is desired because banks give a low rate of interest in savings account (3-4%) deposits and no interest in current account deposits. A high CASA ratio indicates a lower cost of funds.
Example: CASA ratio is 43.48%. It means that ~43% of the total deposits are from current and savings accounts.
A loan asset becomes non-performing when it ceases to generate any income for the bank. Gross NPAs (non-performing assets) are the total loans classified by the banks as non-performing. Higher NPAs are adverse for the banks. This should be checked to determine the asset quality of the banks.