Want to start investing in bank stocks? First of all, keep in mind that bank stocks are altogether different kinds of stocks due to their unique organizational culture.
Analyzing bank stocks involves taking a detailed look through an entirely separate set of metrics. In this post, we will discover the figures and proportions that we must constantly consider while examining banking stocks.
Although examining bank stocks may appear complicated, the banking industry is considerably simpler than you may think. Furthermore, because banks are closely tied to one another, if you can understand one, you can probably understand the rest as well.
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Understanding Banking Business
Understanding the banking industry’s business and financial operations is a must before learning to analyze banking stocks.
Banks operate on a pretty straightforward business model: customers make deposits with them to keep their money secured and receive interest, and then banks give loans with that money to customers at a high-interest rate.
The “Interest Spread” thus is the difference between both the interest received from its lender and the interest paid to depositors.
In simple words, banks get money as deposits at some interest rate, and then they lend the same to others, keeping the difference as income.
Now that you understand the banking industry and its business model, you might be curious to know how to analyze bank stocks.
So, without any further ado, let’s dive in:
Analyzing Bank Stocks in the Booming Banking Sector
The banking sector is a broad industry consisting of public sector banks, private sector banks, commercial banks, foreign banks, central banks, and regional rural banks.
Fundamental analysis of stocks in the banking industry is done differently. Therefore, we have curated some parameters to analyze bank stocks.
When analyzing the actions of a particular bank, it is best to focus on the following metrics that indicate the bank’s performance and accuracy:
1. CASA Ratio
CASA ratio stands for current account and savings account ratio. Deposits of all types, including current accounts, savings accounts, and fixed deposits, are the main source of banks’ revenue.
The ratio reveals the bank’s total deposits held in both current and savings accounts. A higher CASA ratio is a sign of a profitable bank.
2. NET INTEREST MARGIN (NIM)
NIM, or the Net Interest Margin, is the difference between the interest received by banks from lending and the interest paid to depositors.
This is the bank’s fundamental revenue model. Hence, the NIM must be consistently growing in a strong banking stock.
For example, when an individual opens a savings account, the bank pays an average of 3% interest on the deposits.
When a person borrows money from the bank as a loan, the bank charges around 15% monthly interest. The difference between interest paid and interest received is 12%. So, the net interest margin is 12%.
3. NON-INTEREST INCOME (NII)
The money that banks and other financial organizations make from their non-core operations is known as non-interest income.
These are essentially additional costs the bank charges (loan processing fees, account maintenance charges, credit card charges, transaction fees, penalties, etc.).
To maintain profitability, banks must have non-interest income because relying on just one source of income could be unsustainable.
4. Tangible book ratio
Tangible book value is the value of the bank’s tangible assets. It is a financial ratio that is used to compare a bank’s tangible book value to its current share price.
It is determined by dividing the current market price by the most recent year’s Tangible Book Value for each share.
This ratio goes one step further and excludes banks’ intangible assets, such as goodwill.
(Note: When looking at bank stocks, it’s best to consider the bank’s tangible assets rather than intangible assets, such as goodwill.)
5. NET PROMOTER SCORE (NPS)
Net Promoter Score is the tool that helps to understand customer loyalty and attributes towards banks. A high net promoter score is essential for a bank.
Even though there are still several other essential metrics outside customer loyalty, NPS has gained popularity since it is straightforward and can be compared to competitors.
Numerous businesses, particularly financial firms, use their NPS as an additional performance metric from the perspective of the people.
6. Efficiency Ratio
The efficiency ratio is an indicator of expenses to income. The ratio is used to measure a bank’s productivity and efficiency by dividing non-interest expenditures by income. In simple words, the efficiency ratio shows how much a bank spends to generate income.
For example, an efficiency ratio of 60% indicates that the bank spends around Rs 0.6 for every rupee earned.
The formula is as follows:
Efficiency Ratio = Non-Interest Expenditure / Income
7. Return on equity (ROE)
Return on equity shows the rate of return on equity invested in the business by equity shareholders.
A constantly growing ROE means that the company or bank can generate enough returns for its equity shareholders.
(Return on capital is mandatory to verify in all sectors)
We have explained the ROE ratio in detail in our article on growth stocks.
8. Nonperforming Assets (NPA)
Non-performing assets (NPA) show the total number of non-performing loans in a bank.
These are recorded on a bank’s or similar financial organization’s balance sheet. A bank with strong fundamentals should have a low NPA.
(Any person who has taken a loan and has not made a payment in the last 90 days is considered a non-performing asset.)
GROSS NPA = TOTAL NON-PERFORMING LOANS / TOTAL LOANS
9. Capital Adequacy Ratio (CAR)
The Capital Adequacy Ratio (CAR) measures the relationship between a bank’s capital and risk.
The CAR of a bank is monitored by national authorities to ensure it can sustain a fair level of risk and adheres to legal financial regulations. It represents a bank’s sustainability in some way.
In simple words, it indicates how much capital the bank needs to hold in reserve to reduce the risk of insolvency. A bank with solid fundamentals has a continuously high CAR.
(Note: if the gross NPA crosses the CAR, it means that the bank is in the bankruptcy stage).
These are some of the most important parameters to analyze before investing in any bank stock. Investing in the right stock is more important than investing a high amount in stocks.
So, make sure you examine each factor thoroughly before making any investment.
But now you might be wondering, that why should we invest in banks. What is so special about the banking industry?
Here’s the answer:
Investing in Banks
The banking sector has seen a remarkable transition over the past decade that has improved its overall strength, cleanliness, transparency, efficiency, speed, regulation, and competition levels.
Every country’s economic expansion is backed by the banking industry. The Indian economy has been rapidly growing for the past several years.
Hence, we can expect the banking industry to grow as well. This gives us a clear understanding that the banking industry is rising and investing in banks can be worthwhile.
As investors find it difficult to analyze bank stocks, I have tried to take into account all the parameters that you should check before investing in any bank stock.
I hope you find this article informative and easy to understand. I have simplified each concept to help you understand.
All the information and strategies shared in the above article is solely for educational purpose. We do not promote any stocks or sectors. And also, don’t guarantee any stock profits.
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