Evaluating Banking Stocks: First Steps

We all know how banks play an important role in the stability of any economy. It is also known that the primary activities of a bank includes accepting deposit and lending loans both for an interest. Hence, in high interest rate environments, now would think banks will certainly do well. But is interest income (from loans) and interest expense (to deposit holders) enough to check a bank as a profitable stock?

Banks today are more dynamic than ever with many secondary functions performed. They also have exposure into the equity and debt markets across the world which are quite volatile. Considering their importance in the local markets and past financial crises, banks across the world are regulated. Hence, when investing in a banking stock, it is essential to look at multiple factors than just interest income and interest expense.

Some of the metrics to look at include:

1. CET1 (Common Equity Tier 1) Ratio: every bank needs to adhere to and report its CET1 ratio. Why is this metric important? CET1 ratio is the common equity tier 1 (i.e. solely the common shares without any preference shares or any other kind of shares) divided by risk-weighted assets. Assets for a bank majorly include different kinds of loans given since their loans generate an income. Risk-weighted assets simply assigns a risk component to those assets. Look at it this way, you give a loan to two people – one is a student with no strong financial background and another one is the Manager in a company. Obviously, your chances of receiving the principal amount of loan is higher from the manager than the student with no strong financial background. Hence, if you were to calculate the value of your loan book (assets) based on the chance of receiving your principal loan amount back, you would assign a higher chance (low risk) to the manager and a lower chance (high risk) to the student. This will show the amount that you may actually receive in a realistic world or even a bad case scenario. Similar is the concept for risk-weighted asset. Since the CET1 ratio compares the capital (common equity) of the bank to the assets of the bank, it is a capital measure. Every bank is required to maintain a set CET1 ratio. For example, in 2019, the Reserve Bank of India (RBI) set the minimum CET1 ratio of banks to 7%. This minimum percentage is subject to regular changes and the central banks generally add ‘Additional CET1’ requirements for banks which are deemed to have significant impact on the economy. One such bank in India is the State Bank of India (SBI) which has to maintain additional CET1 capital amount as prescribed by the RBI than other banks. This is a ratio that evaluates whether a bank can sustain the losses with the current amount of common equity (which are the shareholders who bare the highest losses in case of a company shut-down). In case a bank’s CET1 ratio falls below the minimum set by the central bank, the bank is answerable to the central bank and may need a bail out or restructuring. CET1 ratio is the first check in your checklist. Most banks have the CET1 above the requirements. Still, it is better to keep an eye on it in every report. You can see whether the ratio is increasing or decreasing over time and understand where the bank may be standing in the economy.
2. Net Interest Income: This is simply the difference between a bank’s interest income and interest expense. It is a good measure to start evaluating the banking. We can also take Net Interest Margin which is a percentage of net interest income by interest bearing assets (such as loans and advances). It simply measures how much income a bank is able to generate from its assets.
3. Return on Tangible Equity (RoTE): it is a very common metric to calculated by dividing net income by the average tangible equity (ordinary shareholders’ equity – goodwill – intangible assets). The purpose of the metric is to evaluate how efficiently shareholders’ funds are used in generating a profit for the business. The reason why we use RoTE over the general RoE is that the CET1 and other ratios set by regulators is calculated without goodwill and intangible assets. Hence, it is better for us equity investors as well to exclude the two. Also, banks do engage in M&A and this creates goodwill which inflates the value of equity which means the RoE will be less. But removing goodwill and intangible assets removes the effect of M&A and hence, we get the real return on our equity in the form of RoTE.
4. Price to Tangible Book Value (PTBV): The reason we recommend PTBV over PE is first, for a bank, its use of funds is more important than earnings generated solely for price movement. And second, tangible book value is total assets less goodwill and intangible assets which is the basis for regulatory capital requirements. Banks generally focus on maintaining their capital and using them efficiently to generate interest income which is a major chunk of its earnings. Hence, PE is a good metric, PTBV is the foundation.
5. NPAs (Non-performing assets): These are simply the loans which cannot be recovered by the bank and hence, a loss. Banks generally package these together to make an investible security out of it which is called securitisation. Nonetheless, it is good to see how the NPAs of banks have evolved over the years to see the quality of assets (loans) of the banks.

There are many other metrics such as Cost Income ratio, Loans to Deposit ratio, CASA ratio, etc. which are also very useful. However, the above 5 are the most basic ones which should never be overlooked and which are the starting point of evaluating the health of any bank. Once the health has been evaluated, the stock can be considered for investment. For which banking stock may be the best for you depends on your purpose of investment. If you are looking for long-term investment without much iterations, then a bank with best health based on the above metrics may be a good (eg: CET1 ratio way higher than required, very low NPAs. If you have risk appetite and time to evaluate your investment often (say every week) then you may go for private, small banks which may have higher risk, CET1 ratio very close to the requirement or high NPAs. But these require regular evaluation and changes if the bank starts deteriorating.

Hope this article is helpful for you to start looking at banks from a foundational perspective.

Disclaimer: this article is purely educational and has no intent of giving any tips for stock investment or trading.