Banks are among the largest companies on Indian exchanges, and bank stocks make up a large share of the main indices. Yet the usual tools for judging a company — revenue growth, operating margins, debt-to-equity — work poorly for banks, because a bank's business is borrowing and lending money.
This article explains why banks need a different lens, and walks through the measures analysts use instead: margins, deposits, asset quality, provisions, capital and valuation.
Why ordinary ratios mislead
For a manufacturing company, debt is a choice, and high debt is a warning sign. For a bank, deposits and borrowings are the raw material. A bank with no debt would not be a bank.
Similarly, a bank's “revenue” is mostly interest earned, and its main cost is interest paid. Looking at total income growth alone says little about whether the bank is lending profitably or safely.
And the biggest risk in banking does not show up in operating margins at all. It is the risk that borrowers fail to repay. A bank can report strong profits for years while building up bad loans that only become visible later.
So bank analysis focuses on four questions. How profitably does the bank lend? How cheap and stable are its deposits? How good are its loans? How much capital does it hold against losses?
Margins and deposits
Net interest income is interest earned on loans and investments minus interest paid on deposits and borrowings. It is the core earnings of a bank.
Net interest margin (NIM) expresses net interest income as a share of the bank's interest-earning assets. A higher margin means the bank earns more on each rupee it lends relative to what it pays for funds. Margins differ by business model: a bank focused on retail and small-business lending usually earns wider margins than one focused on large corporate loans.
CASA ratio is the share of deposits held in current and savings accounts. These deposits usually pay little or no interest, so a high CASA ratio means cheaper funding. It also tends to be stickier than large fixed deposits chasing the best rate.
Deposit growth matters as much as loan growth. A bank that grows loans much faster than deposits must fund the difference with costlier borrowing.
Cost-to-income ratio measures operating expenses against operating income. Lower is more efficient, though a bank investing in branches or technology may run higher for a period.
Asset quality and provisions
Non-performing assets (NPAs) are loans on which repayments have stopped for a defined period. Banks report gross NPAs, the total of such loans, and net NPAs, after deducting provisions already set aside.
Provisions are amounts set aside from profits to cover expected losses. They reduce reported profit when they are made.
Provision coverage ratio shows how much of the bad loans have already been provided for. Higher coverage means fewer future surprises from loans already known to be bad.
Slippages are new loans turning bad during a period. Rising slippages are often the first sign of trouble, before NPA ratios move noticeably.
Restructured and stressed loans — loans whose terms have been eased — can hide stress that later becomes NPAs.
Credit cost — provisions as a share of loans — shows how much lending is costing the bank in losses.
Look at trends over several years and across the economic cycle. A bank with low NPAs in a boom may look very different in a downturn. Concentration matters too: heavy exposure to one sector or a few large borrowers raises the risk of a sudden jump in bad loans.
Capital and profitability
Capital adequacy ratio compares a bank's capital with its risk-weighted assets. It shows how much cushion the bank has to absorb losses before depositors are affected. Regulators set minimum levels; banks comfortably above them have more room to grow and to absorb a bad year.
Banks with thin capital may need to raise more, often by issuing new shares, which dilutes existing shareholders.
Return on assets (ROA) measures profit relative to total assets. Because banks are highly leveraged, even a modest ROA can be good.
Return on equity (ROE) measures profit relative to shareholders' equity. It is the measure most directly linked to shareholder returns, but a high ROE achieved with thin capital and risky lending is less valuable than a slightly lower ROE built on a strong balance sheet.
Valuation, and a short checklist
Banks are commonly valued using price-to-book value, comparing the share price with the bank's net worth per share. A bank that consistently earns a high return on equity with clean asset quality usually trades at a higher multiple of book value; a bank with weak returns or doubtful loans trades lower.
Adjusted book value, which deducts net NPAs from book value, gives a more conservative picture for banks with significant bad loans.
A short checklist before buying a bank stock:
Is net interest margin stable or improving, and how does it compare with banks of a similar business model?
Is the deposit base growing, and is CASA healthy?
Are gross and net NPAs stable or falling, with rising provision coverage?
Are slippages under control?
Is capital comfortably above the minimum?
Is the price-to-book multiple reasonable for the bank's return on equity and asset quality?
Read the bank's quarterly results presentation and the notes on asset quality, not just the headline profit. And remember that holding several bank stocks is a concentrated bet on one sector, however different the individual banks appear.
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Frequently Asked Questions
Why can't I analyse bank stocks like other companies?
Because borrowing and lending are a bank's business. Debt is its raw material, revenue is mostly interest, and the main risk is borrowers failing to repay, which ordinary ratios do not capture.
What is net interest margin?
Net interest income — interest earned minus interest paid — as a share of interest-earning assets. It shows how profitably a bank lends relative to its cost of funds.
What does a high CASA ratio mean?
A larger share of deposits in current and savings accounts, which usually cost less than fixed deposits and tend to be more stable, giving the bank cheaper funding.
What is the difference between gross and net NPA?
Gross NPA is the total of loans on which repayments have stopped. Net NPA deducts the provisions already set aside against them.
How are bank stocks usually valued?
Commonly using price-to-book value, judged against the bank's return on equity and asset quality. Adjusted book value, net of bad loans, gives a more conservative view.
Related Reading
- Debt funds and the bank paper they hold
- Reading a bank's price chart
- The general ratios, and their limits
- Reading quarterly results
- Why several banks is one sector bet
- Judging companies, from the beginning
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