How to Value Banking Stocks?

Banking sector has been an investor's favorite over the years and rightly so. Due to India's huge population base, credit off-take has been surging over the past decade. Deposit growth has increased due to rise in disposable incomes over the years.

The Indian Banking system consists of 26 public sector banks, 25 private sector banks, 43 foreign banks, 56 regional banks, 1,589 urban co-operative banks and 93,550 rural co-operative banks.

With such stiff competition, it becomes difficult for an investor to separate high quality banks from the rest. What are the factors does he need to look at while assessing banks? We go through some of the most critical parameters while evaluating a Banking stock:

1. Net Interest Margin (NIM): The main business for a bank is lending to customers and accepting deposits from customers. A bank charges interest for lending money and pay out an Interest to the customer to keep its deposits in the bank. This difference between the interest it earns and the interest it pays out it is called 'Net Interest Income'. This is the major source of earning for the bank. Other sources of income include Wealth management, fees charged for various services, mutual fund distribution sales, insurance distribution sales, income from treasury i.e. investment in bonds, equities etc.
   
   A standalone higher NIM might not always be good for the bank. A bank charging higher interest rates for loans might turn away customers to another bank charging lower rates. The ability of the bank to increase its profitability without constantly increasing rates signals better efficiency. For this very reason, it's better to look at NIM with respect to ROA. NIM-ROA gives a fair idea of a banks competitiveness and efficiency. A bank with an NIM of 3% and ROA of 1% (NIM-ROA = 2%) is much more efficient and competitive than a bank with an NIM of 5% and ROA of 1.5% (NIM-ROA = 3.5%).


2. Non-Performing Assets (NPA): The loans provided by the banks to its customers form a part of its assets (Also known as Total Advances). If the borrower doesn't repay the loans, these assets become Non-performing assets. The % of NPA to total advances indicates the asset quality of the bank. A higher % indicates poor quality.
   
   A bank has to subsequently provision for these NPAs so that the current deposit demand for customers is met. The higher the NPA, the higher the provision and lower the profitability since these funds cannot be deployed elsewhere to earn profits for the bank.


3. Price to Book (P/B): The traditional method of P/E multiples doesn't a paint a true picture while valuing a bank. As explained above, a bank has to provision a certain amount of funds to take care of risky assets in its portfolio. If a bank makes higher provisions, it net profit decreases and if it makes lower provisions, its net profit is inflated. Thus earnings can be easily manipulated based on provisions.
   
   Since a bank's assets are financial, its ability to grow its capital is important. Capital growth means growth in net worth i.e. Book Value. Hence, Price to Book Value becomes a critical factor in valuing a bank.

The above factors need to be used in totality and compared with its peers when evaluating a particular banking stock.