If you ever apply the valuation criteria that you use for the non-financial businesses, to the banks, you would definitely get surprising results. For example, the debt to equity ratio in the range of 6 to 10, will spook you. When you look at the stock prices of banks, you will be surprised to see some banks perennially selling below the book value. In most cases, you will not see the banks losing money in their long history, partly because the ones which do lose money, either lose their solvency or their independence. They are bailed out by the government and merged with others. You would see that the banks which are doing well keep growing at steady pace. At the same time, you would note that the markets are not giving them the kind of P/E you would expect for a steadily growing services company.
What sets banking business apart from non financial businesses? How should we take into account these differences while valuing a bank? In this article we will delve into these questions.
A bank is more like a services company but the service it provides – intermediation between the savings and investment – has characteristics that make it a category in itself. The bank uses the deposits to lend money. The size of the bank's business is constrained by the deposits it can attract. The deposits aren't limited by its physical infrastructure of branches. A bank is able to use the deposits as a form of debt to generate returns. However there are many regulatory constraints on how this debt can be utilized by the bank. These regulations ensure that the bank is able to provide adequate safety to the depositors. Within these constraints the bank is free to lend its money to generate adequate returns at reasonable risk. Here is the list of factors which allow a bank to achieve this objective.
- Trust
The history of the bank, the financial strength of its promoters and strong branding, help in building trust. Scale also helps here. People feel safer with a bank which most of their relatives and colleagues bank with. So a higher deposit base begets more depositors.
Indicative Factors: The level of trust is a qualitative factor. But a sure shot indicator of the level of trust is the interest rate a bank pays for its long term fixed deposits. The banks which are considered less trustworthy have to shell out extra money to get deposits. The failed Global Trust bank, even in its heydays, used to pay 1% extra for fixed deposits. This data is readily present and can be used as a proxy.
- Asset Liability Management
The profitability of a bank in the long term depends on how well the bank manages its assets and liabilities.
Indicative Factors: The banks provide data about the maturity profiles of their assets and liability in the annual reports. This data should be read in conjunction with the guidelines on Asset Liability Management from regulators.
- Risk Management
The risk management of the bank is important not only to protect its income but also for the survival of the bank. The Non Performing Assets (NPA) of SBI were 7.18% of its advances in March 1999. But for the government support, the bank would not have survived.
Indicative Factors: Gross NPA, the ratio of gross non performing assets to the total advances is a good indicator of the quality of risk management. This ratio is also dependent on the state of the economy, hence a relative comparison among banks will give you more credible information.
The level of Net NPA, which is Gross NPAs minus provisions made for future losses, gives an indication of the extent to which the bank has covered for the losses. However, I feel that Gross NPA is a better indicator. A bank, which keeps losing money to bad loans and then keeps taking out a chunk from the income to provide for these losses, is not a good bank even if its net NPAs are low.
The annual reports also contain information about the risk management policies adopted by the banks to counter various types of risks like credit risk, market risk, liquidity risk, operational risk etc which can be used to judge risk management in a bank.
- Quality of credit portfolio
Indicative factors: Most banks report distribution of credit risk exposure by industry sector in their annual reports. You can watch out for excessive exposure here.
- Capital Adequacy
The capital adequacy ratio (also called Capital to Risk Weighted Assets Ratio (CRAR)), sets an upper limit on growth. A bank which is seeing good growth in business, yet lacks adequate capital, is forced to augment its capital. For investors, this is an aspect that must be kept in mind while making assumptions on growth.
Indicative Factors: Capital adequacy ratio is mentioned in the results and annual reports. For the year 2007-08, the average CRAR of the nationalized banks stood at 12.10 per cent while that of foreign banks was at 13.10 per cent and of private banks at 14.30 per cent.
- Cost of deposits
Indicative Factors: The higher is the ratio of CASA deposits (Current Account/Savings account) to total deposits, the better for the bank. This ratio is provided in the annual reports. Another metric is the cost of deposits which gives an indication not only of lower interest costs but also the level of trust the bank enjoys.
- Interest magins
Indicative Factors: Net Interest Margin gives an indication of the profitability. However, it should be used in conjunction with other factors. A bank with cost of funds at 5% and returns on loans at 8% is much better than a bank with cost of funds at 8% and returns at 11%, even though the Net Interest Margin is same. The first one has lower risk.
- Operating efficiency
Indicative Factors: The annul reports of the banks include yearly data about the business per branch, business per employee, profit per employee etc. which give an fair indication of the operating efficacy of the bank and changes in operating efficiency. The cost to income ratio is another handy tool to learn what percentage of interest income goes to support operations.
- Asset Composition
Over and above the minimum requirements specified by the RBI, the banks may keep more money in govt securities and other liquid securities. Although the major portion of the earnings come from advances, the volatility in interest rates can change the carrying value of the govt. securities resulting in the treasury gains/losses. The current market regulations allow banks to define what portion of their govt. securities portfolio is held till maturity and what portion is available for sale (AFS). The mark-to-market requirements, which call for valuing the bonds at the market prices, apply only to the AFS portion.
The public sector banks may give loans to priority sectors like farmers, and small scale industries at subsidized rates of interest. Again, this portion of the assets is not profitable. Banks are also allowed to invest up to 5% of their assets in equities. These investments may become a source of returns or troubles depending on how well the bank manages its investments.
Indicative Factors: The Credit/Deposit ratio gives an indication of the percentage of the deposits that have been disbursed as loans. The ratio should not be too low because that would mean the bank hasn't been able to deploy the deposit money profitably. Low Credit/Deposit ratio also means that a major portion of bank's assets is in form of govt securities which makes the bank susceptible to changes in interest rates.
- Quality of earning
If the other income is a significant portion of total income, you should see the composition of the other income. The income from treasury gains, profits from sale of investments and derivatives, should not be considered recurring income. On the other hand, dividends from subsidiaries, fee based income in form of commissions and brokerages may be relatively stable.
Indicative Factors: Interest income as a percentage of total income.Fee based income as a percentage of total income.
- Quality of service
Indicative Factors: This is a qualitative factor and little hard to judge. The investors should not go by stray incidents to term the service good or bad. However, the factors like availability of branches, ATM and other banking channels should be weighed in while evaluating a bank.
Even this lengthy description of factors does not adequately cover the key determinants in the success of a banking business. There are other factors that assume critical importance on a case-to-case basis. For some banks the exposure to currency risks and derivatives can be significant. Similarly, independence on decision making can be a big factor in case of public sector banks which are, at times, forced by the government to lend to certain sectors at lower rates which do not compensate for the associated risks. The waiver of loans and the moral hazard associated with it is another key concern for these banks.
Some banks have large subsidiaries dealing in stocks, brokerages, insurance and other financial sectors. If the subsidiaries are large, you cannot use standalone accounts to correctly judge the strength of the bank.
The banks are a good proxy for participating in the growth of the economy. They should be present in every investor's menu but yes, their accounts are hard to digest. If you want to invest in banks, never be shy of number crunching.
Further Readings
Low-cost deposits key to banks' survival
http://www.livemint.com/2008/08/18004847/Lowcost-deposits-key-to-banks.html
Asset - Liability Management System in banks - Guidelineshttp://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/3204.pdf
Prudential Norms on Capital Adequacyhttp://rbidocs.rbi.org.in/rdocs/notification/PDFs/85410.pdf
Banks witness fall in low-cost deposits' share in Dec quarter
http://www.thehindubusinessline.com/2009/02/04/stories/2009020451650600.htm
1 comments:
One of the best posts in the blog. A must read for every value investor.
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