Master Class 9: How to analyze and value Banking Stocks - NIM and ROA

Last year was not a bed of roses for a lot of banks in the country, especially the public sector banks. A lot of banks had to go through a rough patch, which cost a lot to its depositors and investors. But does that mean all those banks are unsafe for investments? 

No. In fact, a lot of investors who have made it big in the share markets have invested in bank stocks. Also, banking stocks like those of HDFC bank, Axis bank, etc. are fetching good returns. So selecting the right stock has a lion share in determining your returns. 

How to select bank stocks?

As you know, the business of the bank is quite different from the rest. Thus, its financial reports are also unique, demanding a special magnifier to understand the performance. So if you invest in such bank stocks without knowing the actual nature of such businesses, then you will be into sure trouble. Banks accept deposits from common people and promise a certain rate of interest in return. It lends this money to borrowers and charges a higher interest. The difference between them is termed as Spread, which is the bank's actual profit. 

For instance, a bank offers 6% as interest to its depositors and charges 10% from its borrowers. The difference between the two, which is 4% (called Spread), will be the bank's profit. As the business stands unique from the entire lot, the analysis of these stocks is also unique.

So, let's break them down one-by-one. 

Net interest margin (NIM)

The NIM or net interest margin of private sector banks continued to grow and stood at 5% in the early 2017's despite the increase in non-performing assets. However, the PSU's had a troubling trend. These facts might push you to wonder as to what NIM is. 

The Net Interest Margin is a tool both investors and bankers use to measure their profitability and align their strategies. It is the difference between the interest earned from loans and mortgages and the interest paid out to depositors. To sum up, it tells us the spread in terms of percentage. It can also be used as a parameter to measure fund managers' efficiency in managing the firm's assets. 

Net interest margin = (Investment return – interest expenses) / Average earning assets 

Let's take an example. Suppose bank ABC has lent some of its deposits which it received from the public and has achieved a return 1lakh. Note that this is excluding the actual principal. Now it has to give 50000 to its depositors in the form of a specified interest. Further, it's earning assets stand at 10000. Hence, the bank will have a NIM ratio of 5%. 

A positive NIM is to be expected from good stock. A higher net interest margin can be the result of a good demand for loans or other financial products of the bank. Also, a higher margin saves a bank in times of crisis. A negative or declining NIM must trigger caution as it reflects poor allocation or handling of assets. It might also be a reflection of more depositors and fewer borrowers. Monetary policies implemented by the RBI can also affect the NIM. Fluctuating NIM is also an indication that the investor might want to scrutinize the stocks under their holding once again because this might be a sign that the bank is more concerned with hyping profits by compromising on quality. 

Return on assets

The next important tool on which you can back your decision is the Return on assets or ROA. Every business has assets. The efficiency and profitability of any firm depend on its effective usage of these assets. So, Return on assets tells you how efficiently a bank is generating cash out of its assets. It is calculated as follows: 

Return on assets = Net income / total number of assets

Now, picture that you are running a bank. You have an income of 20000 and also have assets worth 100000 under your control. In that case, the ROA will be 20%. This means you are getting a 20% return for every rupee in the assets. Sounds good? 

Have you read our previous Master Class: 7 Things to look for in an Annual Report ?

Why is this important?

The assets of banks are mainly composed of cash, which is collected from its depositors. Optimal usage of this variable becomes crucial for any bank which hopes to bag a good profit. In that case, ROA tells you how effectively the bank works to find new borrowers. In other words, it demonstrates how much the bank makes on every single penny it has invested on assets. A higher Return on Assets is usually preferable.

Furthermore, it means that the bank has effectively put all its assets to work. On the other hand, a low or negative ROA might point out the bank's inefficiency in the allocation of resources, which is surely a red signal for any investor. Hence, it is always better to compare two competitive banks to get a clear picture. Also, please don't fail to take into account the scale at which it operates while doing so. As far as the Indian banking market is concerned, you can classify a bank's ROA as good if it is anywhere between 1-3%.  

A few other things you must pay attention to: 

• It is always good to draw a comparison between all the ratios of various stocks. As basing your decision on anyone ratio can be misleading. So use Excel sheets. Open columns for all ratios such as ROE, ROA, NIM, CAR, advance growth, etc., and draw a comparison between different banks. This will shed a light on how well the bank is performing as well. 
   
• Always bring out the comparison between its competitors and its past performance. This will help you see many key factors and assist you in landing on the most accurate stock that suits your portfolio and financial objectives. 

Adding to that, if you are going to invest in a bank that lacks diversification in terms of lenders or borrowers, then you are going to be in real trouble when things go out of your hand. Let's suppose a bank has its borrowers composition dominated majorly by industrial loans. If the industrial sector doesn't perform well, then the money lent to them will be at risk. How can you check all these details? Just log on to the Ticker stock screener and type the bank you want to look for. Then go to the documents section and click on the company presentation. 

You will find everything from business mix to average deposits here, as shown in the picture. You might as well want to check this out to get more details on the topic: Click Here 

To sum up 

It all comes down to one simple formula. Invest right and quit worrying. A perfect analysis backed by logic and aligned with your risk profile, objectives, etc., will turn your investment into something that is nothing less than an excellent choice. So the next time you lose something, it means you lack in your analysis. So analyse properly, and every other thing will fall in line.

Hop on to the next blog series: Return on Capital Employed and Return on Equity - ROCE Vs ROE

To read all Master Class series Click Here