Bank Stocks Analysis: Key Ratios To Look For Before Investing

Experts suggest that you must do thorough research about a business before making an investment decision. Apart from the technical and fundamental analysis, first, you must understand the business itself. How the business operates its activities to generate revenue goes a long way in gauging its future growth prospects.Where most businesses generate revenue through the sale of goods or services, the primary product that a bank sells is money. Accordingly, the stock analysis is performed differently for banks than how it is generally done for the majority of businesses.As the business model, financial reporting, and financial ratios used in the banking sector is unlike other businesses; you must first learn about the working and business model of banks to analyse their stocks better.

Banks undertake various activities to generate revenue for themselves their customers and their shareholders. Some of the activities are as below:

• Interest on Loans Banks offer loans to their customers and charge interest on the principal amount. The interest received is revenue for the banks.
• Charges on Banking Services Banks generally charge some fee for providing services to their customers. Some of the common fees charged are Locker fee, account maintenance fee, overdraft fee, and a transaction fee on online payments and money transfer fees.
• Charges on Complimentary Services There are many other complimentary services offered by banks such as insurance schemes, mutual funds, certificates of deposits, notary services, chequebooks, etc. These services may require a nominal fee or brokerage fee to be deposited with the bank in exchange for these services.

As part of their financial statements, every bank generates financial figures periodically (quarterly and yearly) that indicate its overall performance. Based on these figures, various financial ratios are calculated to understand and analyse the market value of stocks of banks .Banks must strike an ideal balance between their asset growth and liabilities/risks that should be reflected in their figures. Below are some key financial ratios that indicate the performance of a bank.

• Advance Deposit Ratio (ADR) ADR is a crucial progress indicator of all financial organisations. It is a ratio of the total advances (loans) to the total deposits of a bank. This ratio reflects the capabilities of a bank to utilise its available funds. A higher ADR suggests that the bank is generating more credit from its deposits. You must prefer a bank that maintains a lower ADR. Also, while comparing the ADR of different banks, ensure that the banks are of similar size and makeup.
• Equity Multiplier (EM) Ratio EM is a financial ratio that suggests how much of the assets of the company are financed using shareholder’s equity. It is calculated as below:EM = Total assets / Total Shareholder’s equityA low EM value indicates that a business is using more of its equity than debts to buy assets. Generally, Banks with a lower EM are safer since their debt burden is less. An EM value within 15 is considered safe for banking institutions.
• ROA (Return on Assets) The ROA is a kind of ROI(return on investment) metric that indicates the profitability of the bank to the total assets. It is calculated as below:ROA = Net Income/Total AssetsThe higher the ROA, the better since it suggests that the bank is earning more on lesser investment. Since the banking business model is based on public deposits, it generally has lower ROA values. It is suggested that the banks should have a minimum of 1% ROA value.
• ROE (Return on Equity) The ROE metrics indicate how efficiently a business is generating returns using the funds collected from its investors. It is calculated as below:ROE = Net Income / Total Shareholder’s equityWhile most businesses focus on EPS(earnings per share), ROE is more relevant for banking institutions since it can provide a better assessment of the growth and market worth of banks. The higher the ROE value of a bank, the higher is the profitability for its shareholders. Generally, an ROE greater than 15% can be considered acceptable.

As discussed above, the relevant financial metrics can help you get an overall picture of the bank’s performance. The financial data can be fetched from various business magazines and financial websites to calculate the financial ratios discussed before.Ensure that the most prominent values i.e ROE, EM, and ROA should not deviate much from their ideal figures(ROE – Min 15%; EM – Max 15; ROA – min 1%). Also, the product of ROA and EM must not go below 15%. If this product value for a bank falls below 15%, it is suggested to refrain from investing in its stocks.Also, a higher Net Interest Margin(NIM = (Investment returns-interest expenses)/Average earning assets) is desirable, which indicates that the bank can be expected to deliver good results in the long run.Apart from the above-discussed metrics, other indicators of a bank's performance include gross NPA(non-performing assets), net NPAs, provisioning coverage ratio, capital adequacy ratio, etc., that can give you more clarity on the bank's current situation.If as an investor, it is overwhelming for you to do the required analysis, you can contact a financial firm or a financial analyst to help you with the detailed analysis before investing in stocks of banks.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.