Banking sector is the back bone of any country which provides the adequate liquidity for any cash needs and working capital management. Individuals deposit their savings with the bank to earn interest from the same and the companies deposits the excess cash with the banks as well. To analyze the valuation methodology of the sector we will first check their business to know how the banks generate revenue and do the expenses to run business and then we will check the important ratios and valuation methods to check the financial health of a bank. For the banking sector, capital or cash is both the raw material and products and all the interest incomes and expenses are different types of cash/capital flows only.
Net Interest Income
Net interest income is calculated as the difference between the total interest earned and the total interest spent over a period of time. Let us first see the different ways of earning and spending the interests for a bank.
Banks earn interest mainly from the below business transactions
Banks expense interests for the following business transactions
Net Interest Income is calculated as
Net Interest Income = Total Interest Earned – Total Interest Spent
Net Interest Income is used as an important parameter to analyze the efficiency of a bank. It specifies how effectively a bank perform its normal business transactions and lending and borrowing operations to earn more income.
Key Financial and Performance Ratios
Let us visit the important key financial and performance ratios to evaluate the efficiency and business excellence of a bank. The important ratios are
Net interest margin (NIM)
Net interest margin denotes a bank’s efficiency to generate more profit from its total assets. The assets denote the loan advances, different investments, cash reserves with the RBI and total call money.
Net Interest Margin (NIM) =
(Net Interest Income / Average total assets)
Average total asset is calculated from the average of total assets at the starting and at the end of the reporting period.
NIM is also used to compare one bank’s efficiency with other banks. The higher the NIM, more efficient the bank is.
Operating profit margins (OPM)
From the net interest income, banks bear the operational expenses including the administrative expenses, employee salary expenses, IT infrastructure expenses and other operational expenses. The Operating profit is calculated by deducting the operating expenses from the Net interest income.
Operating Profit Margin (OPM) is calculated as
Operating Profit Margin (OPM) =
(Net Interest Income – Operating Expenses)/ Total Interest Income
Operating profit margin denotes a bank’s efficiency to generate profit from the Net Interest Income. Higher the OPM; better the efficiency and profitability of a bank.
Credit to Deposit Ratio (CD ratio)
This ratio indicates the percentage of the funds lent by the bank to other borrowers and individuals as loans of the total funds raised through different savings and fixed deposits. This ratio indicates the bank’s ability to expand its business or lending with the limited source of capital.
This ratio has to be optimal based on the bank’s business objective and regulatory guidelines. Too much lending compared to deposit increases the non-performing assets and credit risks while too less lending compared to deposit indicates bank’s inability to expand the business in spite of having adequate liquidity. Keeping excess cash more than what is required by the norms (SLR and CRR) is not desirable for a bank from business point of view.
Capital Adequacy Ratio (CAR)
A bank’s capital adequacy ratio (CAR) is the ratio of total qualifying capital including Tier I and Tier II capital to the risk adjusted assets. It denotes the liquidity position of a bank which has to be kept more than the regulatory authority or the central bank requirement.
CAR ratio for all the banks is set by the central bank which has to be followed for day-to-day business operations and business expansions. CAR ratio below the standard ratio denotes insufficient capital or liquidity position of a bank while higher CAR ratio denotes the strong health of a bank.
CAR is calculated as
Capital Adequacy Ratio (CAR) =
(Tier I Capital + Tier II Capital) / Risk adjusted Assets
Non-Performing Asset Ratio (NPA)
Non-performing assets denotes the low quality loans which have very high chances of being default. Because of lower quality the banks may lose the whole money lent to the customers as loans in this category. The NPA is calculated from the Net non-performing assets and the total loans given to the customers. The calculation formulas are provided below
Net NPA = Gross NPA – Provisions
NPA Ratio = Net NPA / Total Loans Disbursed
Higher NPA ratio denotes high value of low quality loans while lower NPA ratio denotes low value of low quality loans. For a bank, it is always desired to have very low NPA ratio. Lower the NPA is, better the bank’s loan portfolio or future business outlook.
Key Valuation Parameters
For the banks “Price to Book Value” or P/BV price multiple is used to evaluate the share performance.
Reasons behind using the P/BV Ratio instead of other price multiples
Sales or total loan disbursement can be manipulated by giving more loans to the customers including more bad loans. The sales data does not distinguish loans with poor credit quality. So P/S ratio cannot be used.
Earning can be easily manipulated by manipulating the amount of non-performing assets and provisions which is completely determined by the bank itself. Earnings is not a clear indicator of a bank’s performance as there is no strict guidelines for non-performing assets and provisions. So P/E cannot be used to check the share valuation.
Cash flow can also be manipulated after becoming more aggressive in business and giving loans to poor credit quality borrowers with very high interest rates. So P/CF cannot be used in this case as well.
Book value cannot be manipulated easily by a bank compared to other parameters like earnings, sales and cash flow. Because of these reasons P/BV or “Price to Book Value” ratio is used as the main valuation method. P/BV ratio is used to check whether a bank’s share is undervalued or overvalued.