Classroom | When investing in bank stocks, what are the key parameters I should look at? (Equity: Part 18)

Banks are chiefly in the business of borrowing and lending money.

For the principal activity of lending, banks earn a spread, which is the difference between the cost at which they borrow funds and then lend it to their customers.

Banks also earn returns on their investment portfolio.

Interest margin or the difference between the yield on assets such as loans and investments and cost of funds affects a bank’s net interest income.

So, to see whether a bank makes a profit on its lending operations, we need to track net interest income, or the difference between a bank’s interest income and the interest it pays out.

Access to cheap funds is crucial in this regard, especially growth in Current and Savings Accounts (CASA) that come at little or no cost. Since most lenders chase better-rated assets, cost of funds is a key differentiator of strong banks.

Non-interest income, such as commission income, income from the sale of financial products or income from foreign exchange operations, is an important source of revenue for banks as it flows directly to the profit.

The cost to income ratio (operating expenses/net income) is a good indicator of efficiency. If investments are not utilized effectively, it results in a high cost-to-income ratio.

Asset quality is a decisive factor determining a bank’s health. When a client defaults on repayment of principal and interest for more than 90 days, the loan is termed as a non-performing asset (NPA) and the bank must start making provisions by setting aside income.

Net NPA is gross NPA minus the cumulative provision that the bank has set aside for bad debts. The percentage of these provisions taken in the financial statement to the total loans made is called the credit cost of the bank and has an important bearing on profitability.

The other number that has a bearing on a bank’s ability to grow is the Capital Adequacy Ratio, stipulated by the RBI. A CAR of 10 percent means that out of every Rs 100 that a bank gives out as a loan, Rs 10 must be from the bank’s capital. In other words, to make a loan of Rs 100, a bank should have Rs 10 of its own capital.

The risk weight that banks assign to their loan portfolio depends on the underlying quality of the book. The risk weight on loans, stipulated by the RBI, is a function of how risky the RBI perceives a particular category of loan to be. This differs across sectors. So in simple terms, if an asset is perceived to be riskier (say real estate), it will attract a higher risk weight and the bank has to set aside higher capital towards that lending.

Two banks may have similar loan growth but one may be consuming less capital than the other if the risk profile of lending is better.

Price to Book Value as well as RoA and RoE are the other important valuation tools for banking companies.