The bull market continues to run on strong legs with markets recovering swiftly from the scare created by global macros in early August. Finding undervalued or reasonably valued stocks feels akin to looking for a needle in a haystack. Yet, if investors search patiently, pockets of value can always be found — for instance, the banking sector right now.
While Nifty 50, Nifty Midcap 150 and Nifty Smallcap 250 have gained 16, 28 and 29 per cent year-to-date (YTD), Nifty Bank has gained just 6 per cent. The Nifty Midcap 150 and Nifty Smallcap 250 indices are at 18 per cent and 26 per cent premium to their five-year average P/E respectively. Meanwhile, the Nifty Bank is just at a 3 per cent premium to its five-year average price to book value.
Here is a lowdown on how to use key banking metrics to identify good quality banking stocks.
Do note that you may not have to calculate the ratios discussed here all by yourself, since all the banks lay bare these ratios in their investor presentations. Just understanding where those ratios come from would suffice.
Net Interest Margin – Cost of Deposits – Yield on Advances
Pressure on the NIMs (Net Interest Margin) arising from banks’ need to raise deposits to fund credit growth, on the one hand, and yields on loans coming off their highs, on the other, is a trend seen in recent times.
Since Cost of Deposits(CoD) and Yield on Advances (YoA) heavily impact NIM, it makes sense to look at them in unison rather than in isolation.
CoD is nothing but interest expended on deposits during a period, divided by average deposits for that period. Expressed in percentage, it indicates how much interest a bank pays its deposit holders. In general, interest rate on term deposits is higher than that of savings accounts and banks don’t pay interest on current account balances. So, a bank with a higher proportion of current accounts and savings accounts (CASA) will enjoy a lower CoD.
For example, ICICI Bank, which has a higher CASA ratio (CASA deposits divided by total deposits) of 41 per cent, has a CoD of 4.8 per cent, while Karnataka Bank, which has a CASA ratio of 31 per cent, has a CoD of 5.5 per cent (Q1 FY25).
YoA is simply the interest earned on advances during a period divided by average advances for that period and it is expressed in percentage. Basically, it is an indicator of how high a bank’s products are priced. Banks generally price the loans proportionate to the risk that they undertake. A loan secured by a collateral will have a lower rate of interest compared to something like an unsecured personal loan. And so, banks with higher exposure to riskier loans — such as personal loans, credit cards and microfinance loans — have higher YoAs. That does not mean that one should hunt for banks with higher YoAs. While such loans have a higher yield, there is a high probability of their becoming delinquent and worthless, if not effectively managed.
NIM is roughly the difference between the rate (%) at which a bank earns interest and the rate at which it pays interest. A bank earns interest on loans and investments and pays interest on deposits and borrowings. NIM is calculated as net interest income earned (interest earned minus expended) during a period divided by average interest earning assets (loans and investments). CoD and YoA are the major determinants of NIM. A decline in YoA and/or a rise in CoD will affect NIM adversely and an increase in YoA and/or decline in CoD will impact NIM favourably. For example, in Q1 FY25, Canara Bank shed 5 bps of YoA (QoQ) and saw 20 bps rise in CoD, resulting in NIM slipping by 15 bps. Given two similar banks, the one with a higher NIM is the better of the two, provided it exudes quality in other aspects, such as asset quality.
Credit deposit ratio (CDR)
High CDRs have been hitting the headlines in the recent quarterly results of banks, with banks finding it difficult to raise deposits to meet the demand for credit. CDR is the ratio you get when you divide the balance of advances by that of deposits at a particular point of time. For e.g., as of Q1 FY25, State Bank of India had advances worth around ₹38 lakh crore and deposits worth ₹49 lakh crore, making its CDR 78 per cent.
Banks are statutorily required to keep 4.5 per cent of deposits as reserves with the RBI (CRR) and another 18 per cent in liquid assets such as gold, government securities and cash (SLR). This apart, banks need to maintain High Quality Liquid Assets (HQLAs) as part of their LCR (Liquidity Coverage Ratio), large enough to meet 30-days’ worth of net outgo from deposits under stressed conditions. This leaves banks with a ballpark 75 per cent of deposits to disburse as loans.
However, if a bank has enough borrowings (such as bonds) or sizeable own funds from its capital to lend out, it can afford to have a higher CDR, though at the cost of higher interest on such bonds eating into the NIM. For example, a certain bond of HDFC Bank, maturing after 94 months, is available in the market with a coupon rate of 8 per cent, while the bank is offering term deposits at 7 per cent for the same maturity. Here, the cost of the bond is higher than that of deposits. In such a case, if a bank were to defend the NIM, it may have to find ways to boost the YoA; disbursing riskier loans (assuming quality loans) being one of them.
HDFC Bank has a CDR of 104.5 per cent, driven by the merger of erstwhile HDFC Ltd’s advances/loans with that of the bank. The merger also resulted in the bank taking over the high-cost borrowings of HDFC Ltd., which has led to erosion of NIM post the merger. Issue of further bonds for incremental loans might only dent the NIM. The management has guided for loan growth to be slow in FY25.
SBI, on the other hand, is comfortably placed with a CDR of 78 per cent (even stronger at 69.3 per cent with respect to domestic operations) and is sitting on a pile of excess SLR assets of ₹3.7 lakh crore. Hence, unlike HDFC Bank, SBI’s management has guided for a strong 15 per cent loan growth this fiscal.
Asset quality ratios
Over the better part of the past decade, shares of private banks commanded a premium over their public sector counterparts, for the simple reason that their asset quality was superior in comparison. Lately, public sector banks too have upped their game in this regard, with some of them making a good case for investment. Here are four key measures to assess the asset quality of a bank — GNPA ratio, NNPA ratio, PCR and credit cost.
The Gross NPA ratio measures Gross Non-Performing Assets (GNPAs) as a percentage of advances. A Non-Performing Asset is one where interest due on a loan has not been serviced by the borrower for more than ninety days. The Net NPA ratio measures Net NPAs (Gross NPAs minus provisions) as a percentage of advances. It is desirable to have both these ratios at levels as low as possible.
The Provision Coverage Ratio (PCR) measures the extent to which the Gross NPAs have been provided for. A higher PCR and lower NNPA ratio indicate conservative stance of the management in recognising bad loans. But this will have a bearing on profits.
Credit cost is a ratio of provisions and write-offs to average advances. Again, a higher credit cost would mean lower profits. Once legacy bad loans are provided for/written off and as the quality of underwriting incremental loans improves, credit cost will naturally trend downwards and profits will improve.
For example, in FY20, Punjab National Bank had a GNPA ratio of 14.2 per cent and a credit cost of 2.9 per cent. As asset quality improved over the years, the GNPA ratio and credit cost as of Q1 FY25 stand at 5 per cent and 0.32 per cent respectively. Consequently, the bank’s valuation (price to book value) has gone up from about 0.4x in June 2020 (when FY20 numbers were released) to 1.09x now.
Capital to Risk-weighted Assets Ratio (CRAR)
CRAR indicates the buffer a bank has against unexpected losses. It is calculated by dividing a bank’s capital funds by its Risk-weighted Assets (RWA). RWA is the sum of a bank’s various assets multiplied by their respective risk weights. Riskier assets have higher weights.
Capital funds is the sum of CET-1 (Common Equity Tier-1), AT-1 (Additional Tier-1) and Tier-II capitals. CET-1 roughly consists of share capital, securities premium, statutory reserves and other free reserves and assumes the highest importance of the three. This is because, CET-1 capital is of the highest quality of the three and the first to absorb losses in stress scenarios.
As per RBI norms, the minimum CRAR is 11.5 per cent and minimum CET-1 is 8 per cent (5.5% + capital conservation buffer of 2.5%). A higher ratio means the bank is better positioned to handle financial stress. While a CRAR higher than the regulatory minimum may be advantageous in times of financial stress, too high CRARs could suggest under-utilisation of capital resources. It is important to have a thorough contextual understanding before judging a bank’s CRAR as too high.
At a given level of capital funds, the same bank, when it has higher level of risky assets such as unsecured personal loans, will have a lower CRAR than when otherwise. Here’s a simplified illustration to understand this. Assume a bank’s capital funds to be ₹100 and its loan book consists of ₹300 in housing loans and ₹300 in unsecured personal loans. The risk weights for housing loans and unsecured personal loans are 50 per cent and 125 per cent respectively. The RWA in this case would be ₹525 (300*50% + 300*125%) and the CRAR would be 19 per cent (100/525). In the same illustration, if the proportion of personal loans were to be higher, say ₹400, and housing loans were to be ₹200, then the CRAR would come down to 16.7 per cent (100/(200*50% + 400*125%)).
Valuation, the ultimate decision maker
Assessing banks on the metrics explained above is only half the job. Good investing decision depends on the valuation at which you bought the shares.
When it comes to banks, price to book value (P/B) is the widely used valuation metric. It is got by dividing the market cap of a bank by its net assets (book value). The ratio captures earnings also to an extent, as the growth in net assets largely comes from net profits ploughed back into business.
The premium in price over the book value will depend on one’s confidence in the sustainability and trajectory of future earnings. An important factor in assessing this is the bank’s RoE (Return on Equity = net profit divided by net assets). RoE is a measure that captures how productively/efficiently a bank is making use of its net assets or book value.
Imagine two banks A and B. A has a P/B of 1.5x and B a P/B of 2x. A’s RoE is 10 per cent, while B’s RoE is 20 per cent. Looking at P/B in isolation leads one to conclude that A is cheaply valued. However, looking at P/B in tandem with RoE, B is the better valued bank, since it commands a premium for its higher RoE. Thus, when evaluating the bank in question, investors can use the pair — P/B and RoE — in comparing the bank with peers of similar size.
This apart, paying attention to other qualitative aspects such as corporate governance and material litigations is absolutely essential. For instance, if one were to look at the solid fundamentals of Tamilnad Mercantile Bank, he or she would conclude that the bank is brutally undervalued, relative to peers. But the fact is that, there are several legacy litigations in relation to the share capital of the bank that are weighing in on the share price, thereby restricting a premium valuation. Here is where qualitative judgements come in. If one believes the legacy litigations in the case of TMB can be resolved, then the stock will see a re-rating, else it can turn into a value trap. Investors need to assess the implications of such qualitative aspects, before taking the investment call.
SOTP
Top banks such as SBI, HDFC Bank and ICICI Bank have material subsidiaries and associates that are engaged in the businesses of insurance, asset management and housing finance, among many others. And the share prices of such banks derive significant value from the performance of such entities. So, it calls for a Sum of the Parts (SOTP) valuation of such banks, rather than valuing the banking business in isolation.
In SOTP valuation, discrete values are arrived at for the standalone bank (based on P/B) and each of the subsidiaries/associates (based on relevant valuation metric for each business); eventually such values are added up to get the overall value of the bank. In bl.portfolio dated August 25, 2024, we had carried the SOTP valuation of SBI, which illustrates how about 30 per cent of the bank’s share price could come from its key subsidiaries.