I have discussed about the various factors or parameters in analyzing a bank in some earlier posts (see here and here). In this post, I will use these parameters to evaluate a real example.
A warning before I proceed – The wieghtage given to each factor and conclusions derived depend heavily on the temperament and biases of an individual. If you are an investor who likes growth and are ready to take some risks to get a multi-bagger, you may overweight the topline and bottom line growth and pick a bank which is growing rapidly.
On the other hand if you are conservative in nature, you may overweigh the CAR ratio and may actually get nervous if the bank is growing too rapidly. I personally prefer a middle path – I would prefer a conservatively managed bank which is growing at 1.5-2 times the GDP growth rate and hence is likely to give a 15-20% growth rate.
In my world a 15-20% growth rate is adequate, if it can be sustained for 5-10 years. I am not looking for shooting stars.
I am taking the example of Axis bank for this post to demonstrate the process I go through when evaluating a bank. I do not have any position in the stock.
Profitability and its source
The first factor I would look at for in any company is the Return on capital (ROE in case of banks). Any company earning below the cost of capital (over the business cycle) is out of contention. The bank or the company should have an average ROE in excess of 15% over the last 10 years. Axis bank has had an ROE of around 23% over the last 10 years. The ROE has dropped from 32% in 2001 to around 20%, but has generally been maintained above 18% during the entire time period.
I am also interested in understanding the source of the above average returns. In case of a bank, the ROA (return on asset) is an important number. A number in excess of 1.3% is considered good. Axis bank has improved its ROA from 0.8% in 2001 to around 1.6% in 2011.
The improvement in ROA was driven by higher net interest margins and better other income, resulting in higher net profit margins which have gone up from around 1.8% to around 3.7% . So in effect the bank has improved the profitability, both from lending and fee based sources.
Asset Quality
A bank may be very profitable and showing great results, but may have very risky loans on its books. Asset quality is an important factor in evaluating the quality of the earnings of the bank. Unfortunately there is no easy and direct way of doing it.
I typically look at the NPA number, the level of provisioning of the NPA and profile of the assets. It helps to review the distribution of credit risk by industry in the notes to account, to confirm that there is not too much concentration of lending to any specific industry or borrower.
The truth of the matter is that one cannot get a perfect read of the asset quality and has to trust the management. This is the main reason why a long term track record and culture of the bank is important. If the bank has a past history of conservative lending over the business cycle, then one can expect the same to continue.
I am a bit concerned on this count with Axis bank. The bank has been expanding rapidly, especially on the home loans and other retail assets. One cannot be sure if the bank has been conservative in lending.
Safety
The next factor I would look at is the safety or capital cushion of the bank. The ratio to look for is the CAR (Capital adequacy ratio). The bank has on average maintained a CAR of 12.5% and may need to raise more capital to fund future growth.
The next factor to evaluate the sustainability of the earnings is the gross/ Net NPA and level of provisioning. The bank has a gross NPA of around 1% and net NPA of around .26%. The bank was provisioned around 68% in 2010, which means that 32% of the NPA have not been provided for (and could hurt the profitability if these loans cannot be fixed).
The NPA number is very crucial for the banks. It is difficult to be sure about the true NPA of the bank as a bank can play a lot of games to modify this number and thus come up with a desired profit number. One has to just trust the numbers, based on the overall feel of the management.
Growth
If I am satisfied with the profitability and safety of the bank, I would move on to the growth in topline and net profit for the bank. In case of Axis bank, both the numbers have increased in excess of 30%. Clearly the bank is in a lot of hurry to grow.
In addition to the income and profit, the bank has grown its branch network from 139 to 1390 in 2011 and the ATM network from 490 in 2002 to around 6270 in 2011. The bank is thus expanding the retail network which is healthy growth as it helps the bank on the liability side (gather low cost deposit) and also lend to the retail segment (in the form of home loans, personal loans etc).
Cost analysis
Cost is an important factor in the analysis of any industry and more so in the case of the bank. The two crucial cost elements are the cost of funds and the overhead costs.
The cost of funds in case of axis bank has dropped from around 7.5% to around 5%, due to the increasing current and savings deposits. This is a good trend and has enabled the bank to earn a decent net margin (3.7% currently).
The cost to income (or overhead) ratio has gone up from 30% to around 40% level mainly due to the cost of new branches and other such investments. If this ratio is up due to expansion of the branch network, then I am all for it. Axis bank is clearly investing in expanding the branch and ATM network and is benefiting from this expansion too
Competitive advantage
It is also crucial to evaluate the strength of the bank’s competitive advantage and if the bank is working on enhancing it. The competitive advantage comes from the following factors
- Brand : Axis bank is now a well know brand, especially in the urban areas and is constantly being strengthened through advertising and promotion
- Customer Lockin : The bank is improving the lockin by increasing the number of branches, ATM and by providing a wide range of products. The bank can keep increasing the customer lockin by constantly improving the service levels and adding new products.
- Production side advantage : The bank has been able to expand the branch network and increase the number of customers. This provide the bank, economies of scale in gathering deposits (and lower cost of funds) and reduce the per customer cost of servicing them.
- Entry barrier: There is certain level of entry barrier as RBI does not issue new licenses easily (which may change now). As a result the private banks have been shielded from relentless competition and have been able to grow rapidly and achieve scale. Any new banks will to incur years of investment to achieve the same scale.
Management quality
This is the most important and the most difficult factor to evaluate. In the case of axis bank, I can offer a few view points, but these are just that – views or impressions. Each one of us will come up with their own impressions.
I find the management quite aggressive in expanding growing the bank. In some ways, the bank looks like a version of ICICI bank when it was in the growth phase. Some of you may find that comparison unfair as ICICI grew too rapidly and then had to fix the asset quality issues. I am not implying that axis bank has the same issues, but one cannot sure in cases where the growth has been rapid.
The disclosure levels of the bank are quite adequate and the bank provides a lot of detail about asset profile and distribution.
Overall the management is definitely doing the right things and has strengthened the balance sheet and increased its competitive advantage over the years.
Conclusion
I have covered how I would evaluate a bank based on the various factors. As you can see, there is no checklist or points system where if the bank scores well on most of the factors, then at the end of the exercise you would have neat conclusion to buy or sell.
I find the bank passes most of the checkpoints in terms of fundamental analysis, except for my concern on asset quality. The key reason for not pulling the trigger is price – I find the price higher than what I would like to pay.
Showing posts with label Finance and Banking. Show all posts
Showing posts with label Finance and Banking. Show all posts
June 14, 2011
May 23, 2011
Evaluating banks - More factors
In the previous post, I covered several important variables in analyzing a bank. These factors are a good starting point in evaluating a financial institution, but they are not sufficient to arrive at a conclusion.
I am listing several additional criteria I consider personally, when analyzing these kinds of companies. Some of these factors are commonly used by other analysts, whereas some are of interest to me (even though others don’t care about them)
Growth – This is one of the top criteria used by a majority of the investors. A high growth trajectory (in deposit and advances) throws most analysts and investors into ecstasy. As some of you have realized, I like growth, but I am not a big fan. For most businesses, a moderate growth (between 12-15% per annum) is usually more sustainable, attracts lesser competition and provides good returns over the long term.
In the case of banks and other financial institutions, I am almost allergic to high growth. Financial institutions are highly leveraged institutions (read high debt) and as a result, a focus on growth can result in shaky loans which can haunt it in the future.
Take the example of ICICI bank – Don’t get me wrong on this one. I
invested a miniscule amount in the bank IPO way back in the 90s and exited in the mid 2000s.I liked the bank service then (in late 90s the service was actually good!) and liked the way it was conducting its business.
However by mid 2000, the loan growth started increasing and my personal experience (and that of a few friends) of their underwriting standards (criteria to give you a housing or other loan) left me worried. They were much more lax in their standards than other banks. The bank has since then, slowed down its asset growth and is trying to work through its bad loans.
The key point of this story is this – An above average growth is good (though it does not guarantee conservative lending), but a high growth in a bank is a risky proposition. It may all work out in the long run, but I will not bet big on it.
Cost ratios
There are two costs ratios i look at closely when analyzing a bank or financial institution. The first one is borrowing costs, which I covered in the previous post. The other one is the operating cost ratio for the bank.
The operating cost ratio covers all the overheads of the bank such as salary for the employee, branch opening expenses, pension costs etc. I would prefer a downward trend in this number, unless the bank is expanding its network and is incurring the associated costs.
The new private banks such as Axis bank, which are expanding rapidly have an operating cost ratio in the range of 22-24%, where as the older private or public sector banks have this number in the range of 16-18%. I would expect the number to stabilize in this range for most banks as they expand their retail network and the growth slows down.
Credit deposit ratio
This is another important ratio to track. This is the ratio of deposits gathered by the bank to the amount lent out as loans. The RBI guideline is that this number should not exceed 75%. So if you see the number inching to 75%, the bank may have to resort to bulk deposits which are more costly than retail deposits - which means lower spreads and thus lower margins
In case you have a sneaky feeling that your bank is able to take a deposit at 7% from you and lend at 12% and make a nice spread on it – you are right. Banks have a nice thing going with its customers (you and me) – where they get money on the cheap and also charge money for all the other services they provide to us.
Yield on assets
One of the last commonly used ratios is the yield on assets – the return the bank makes on all the loans and other investments. I would like to see a high number, but too high a number could mean risky loans which could hurt the bank profits in the future.
So what is a high or low number? There are no absolutes here. The best option is to compare it across banks and get sense of this number. Currently, the average seems to be around 9.5-10%.
Let’s now look at additional factors which are not commonly followed
Contingent liabilities
I have yet to find a single report which talks of this. So what are contingent liabilities?
Think of these as possible costs, under certain circumstances (such as a particular level of interest rate changes) and hence they are called contingent. If you look at the balance sheet of a bank, all the open derivative and other contracts are included under this number.
For example, this number is around 3.2 Lac crore (yes not a typo) for axis bank which around 2 times their asset base. In a similar fashion this number has ranged between 3-4 for Yes bank and is as low as 25% for public sector and old private banks.
So whats the significance of this number? Does it mean a Yes bank or Axis bank is liable for 2 their total asset value (or 20 times networth ?).
The key point to remember is that these contingent liabilities are a notional value (total contract value) and not the amount which the bank would make or lose on these contracts. The amount which the bank can lose or gain is also provided in the notes to account.
If your head is hurting on hearing some these terms such as notional amount, derivative etc – I will not blame you. I cannot do justice to these topics in the post – you can easily Google it and find out.
The key point to remember is that contingent liabilities are off balance sheet risks (remember Lehman brothers and other investment banks ?). In good times, these derivatives help the bank in making money and are a nice source of ‘other income’ (the stuff which analysts like). However, if the market crashes or something nasty happens, then these contingent liabilities can kill the bank.
Does it mean Axis bank and Yes bank are risky banks ? Frankly I don’t know and an outside investor cannot evaluate the derivative book of a bank. However if you just use common sense in this case, a 25% ratio of contingent liability to asset (as in case of KV Bank) is definitely less risky than a 400% ratio in the case of Yes bank.
If you look at this ratio, the performance of several of the new gen, aggressive banks will make you pause and think
Other contingent liabilities
If you think, I have something against private banks, that is not the case. Public and old private banks have their cockroaches in their kitchen. These banks have pension and gratuity liabilities which have not been provided for. The RBI guideline requires the banks to provide these liabilities in phases and hence we are seeing the impact of these provisions on the results of the banks ( for ex: SBI in Q4).
I am however less worried about these kind of liabilities as they are not open ended and will be provisioned by the banks in the next 2-3 years.
No. of branches and ATM etc
I also like to track the growth in the number of branches, ATM and employees. The raw numbers alone are not enough. One also needs to look at the quality of the expansion – Is the bank expanding in clusters or is it making a thrust into the rural areas (which is good in the long term , though could hurt profits in the short term)
Technology adoption
There are no numbers for this factor. You have to read the annual report for the bank for the last few years and get a sense of how the bank is investing in the technology aspect of the business. Is the bank at the forefront of technology adoption or is it a few years behind the curve ?
Another easy way is to go to a local branch and see if you can get the various services such net banking, anywhere access etc from the bank.
Asset liability profile
Another data point which can be found in the notes to account. This table gives an indication, on whether the bank is exceedingly funded by short term deposits alone. It’s difficult for me to cover this topic in this post, but as a quick pointer – Higher the longer duration deposits, better the risk profile ( remember the term asset liability mismatch ? – if not, please look it up if you plan to invest in a bank)
Management
We now come to a very important and the most difficult factor to evaluate. These are no numbers or tables to evaluate the bank’s management, but if you read the annual report and follow the management, you will get some sense of it.
For ex: Axis bank, ICICI and Yes bank have aggressive management which is looking at growing the bank on both the retail and lending side. HDFC has an aggressive management, but it is also very risk conscious. There are several old private sector banks, which have conservative managements which are growing the banks at a nice pace and with low risk.
Finally we have the public sector banks, where the management is essentially government deputed officers and so it’s difficult to get any picture as such banks (though in some cases there have been individuals who have done well, but then they are posted to some other institution)
Are you exhausted :) ?
We have looked at all the factors which can be used to evaluate a bank. There is unfortunately no mathematical rule to combine all these factors. One has to put all these parameters together and come up with a composite picture of a bank. I will take an example or two in the subsequent posts to evaluate some banks.
I am listing several additional criteria I consider personally, when analyzing these kinds of companies. Some of these factors are commonly used by other analysts, whereas some are of interest to me (even though others don’t care about them)
Growth – This is one of the top criteria used by a majority of the investors. A high growth trajectory (in deposit and advances) throws most analysts and investors into ecstasy. As some of you have realized, I like growth, but I am not a big fan. For most businesses, a moderate growth (between 12-15% per annum) is usually more sustainable, attracts lesser competition and provides good returns over the long term.
In the case of banks and other financial institutions, I am almost allergic to high growth. Financial institutions are highly leveraged institutions (read high debt) and as a result, a focus on growth can result in shaky loans which can haunt it in the future.
Take the example of ICICI bank – Don’t get me wrong on this one. I
invested a miniscule amount in the bank IPO way back in the 90s and exited in the mid 2000s.I liked the bank service then (in late 90s the service was actually good!) and liked the way it was conducting its business.
However by mid 2000, the loan growth started increasing and my personal experience (and that of a few friends) of their underwriting standards (criteria to give you a housing or other loan) left me worried. They were much more lax in their standards than other banks. The bank has since then, slowed down its asset growth and is trying to work through its bad loans.
The key point of this story is this – An above average growth is good (though it does not guarantee conservative lending), but a high growth in a bank is a risky proposition. It may all work out in the long run, but I will not bet big on it.
Cost ratios
There are two costs ratios i look at closely when analyzing a bank or financial institution. The first one is borrowing costs, which I covered in the previous post. The other one is the operating cost ratio for the bank.
The operating cost ratio covers all the overheads of the bank such as salary for the employee, branch opening expenses, pension costs etc. I would prefer a downward trend in this number, unless the bank is expanding its network and is incurring the associated costs.
The new private banks such as Axis bank, which are expanding rapidly have an operating cost ratio in the range of 22-24%, where as the older private or public sector banks have this number in the range of 16-18%. I would expect the number to stabilize in this range for most banks as they expand their retail network and the growth slows down.
Credit deposit ratio
This is another important ratio to track. This is the ratio of deposits gathered by the bank to the amount lent out as loans. The RBI guideline is that this number should not exceed 75%. So if you see the number inching to 75%, the bank may have to resort to bulk deposits which are more costly than retail deposits - which means lower spreads and thus lower margins
In case you have a sneaky feeling that your bank is able to take a deposit at 7% from you and lend at 12% and make a nice spread on it – you are right. Banks have a nice thing going with its customers (you and me) – where they get money on the cheap and also charge money for all the other services they provide to us.
Yield on assets
One of the last commonly used ratios is the yield on assets – the return the bank makes on all the loans and other investments. I would like to see a high number, but too high a number could mean risky loans which could hurt the bank profits in the future.
So what is a high or low number? There are no absolutes here. The best option is to compare it across banks and get sense of this number. Currently, the average seems to be around 9.5-10%.
Let’s now look at additional factors which are not commonly followed
Contingent liabilities
I have yet to find a single report which talks of this. So what are contingent liabilities?
Think of these as possible costs, under certain circumstances (such as a particular level of interest rate changes) and hence they are called contingent. If you look at the balance sheet of a bank, all the open derivative and other contracts are included under this number.
For example, this number is around 3.2 Lac crore (yes not a typo) for axis bank which around 2 times their asset base. In a similar fashion this number has ranged between 3-4 for Yes bank and is as low as 25% for public sector and old private banks.
So whats the significance of this number? Does it mean a Yes bank or Axis bank is liable for 2 their total asset value (or 20 times networth ?).
The key point to remember is that these contingent liabilities are a notional value (total contract value) and not the amount which the bank would make or lose on these contracts. The amount which the bank can lose or gain is also provided in the notes to account.
If your head is hurting on hearing some these terms such as notional amount, derivative etc – I will not blame you. I cannot do justice to these topics in the post – you can easily Google it and find out.
The key point to remember is that contingent liabilities are off balance sheet risks (remember Lehman brothers and other investment banks ?). In good times, these derivatives help the bank in making money and are a nice source of ‘other income’ (the stuff which analysts like). However, if the market crashes or something nasty happens, then these contingent liabilities can kill the bank.
Does it mean Axis bank and Yes bank are risky banks ? Frankly I don’t know and an outside investor cannot evaluate the derivative book of a bank. However if you just use common sense in this case, a 25% ratio of contingent liability to asset (as in case of KV Bank) is definitely less risky than a 400% ratio in the case of Yes bank.
If you look at this ratio, the performance of several of the new gen, aggressive banks will make you pause and think
Other contingent liabilities
If you think, I have something against private banks, that is not the case. Public and old private banks have their cockroaches in their kitchen. These banks have pension and gratuity liabilities which have not been provided for. The RBI guideline requires the banks to provide these liabilities in phases and hence we are seeing the impact of these provisions on the results of the banks ( for ex: SBI in Q4).
I am however less worried about these kind of liabilities as they are not open ended and will be provisioned by the banks in the next 2-3 years.
No. of branches and ATM etc
I also like to track the growth in the number of branches, ATM and employees. The raw numbers alone are not enough. One also needs to look at the quality of the expansion – Is the bank expanding in clusters or is it making a thrust into the rural areas (which is good in the long term , though could hurt profits in the short term)
Technology adoption
There are no numbers for this factor. You have to read the annual report for the bank for the last few years and get a sense of how the bank is investing in the technology aspect of the business. Is the bank at the forefront of technology adoption or is it a few years behind the curve ?
Another easy way is to go to a local branch and see if you can get the various services such net banking, anywhere access etc from the bank.
Asset liability profile
Another data point which can be found in the notes to account. This table gives an indication, on whether the bank is exceedingly funded by short term deposits alone. It’s difficult for me to cover this topic in this post, but as a quick pointer – Higher the longer duration deposits, better the risk profile ( remember the term asset liability mismatch ? – if not, please look it up if you plan to invest in a bank)
Management
We now come to a very important and the most difficult factor to evaluate. These are no numbers or tables to evaluate the bank’s management, but if you read the annual report and follow the management, you will get some sense of it.
For ex: Axis bank, ICICI and Yes bank have aggressive management which is looking at growing the bank on both the retail and lending side. HDFC has an aggressive management, but it is also very risk conscious. There are several old private sector banks, which have conservative managements which are growing the banks at a nice pace and with low risk.
Finally we have the public sector banks, where the management is essentially government deputed officers and so it’s difficult to get any picture as such banks (though in some cases there have been individuals who have done well, but then they are posted to some other institution)
Are you exhausted :) ?
We have looked at all the factors which can be used to evaluate a bank. There is unfortunately no mathematical rule to combine all these factors. One has to put all these parameters together and come up with a composite picture of a bank. I will take an example or two in the subsequent posts to evaluate some banks.
May 11, 2011
Evaluating banks - Key factors
I recently started analyzing financial institutions such as brokerages, banks and HFC (housing finance companies). I wrote about brokerage firms here and here.
In this post, I will be looking at some key factors in analyzing banks. I have written about banks earlier – see here, here and here. I have covered several factors important in analyzing a bank, in these earlier posts and will be analyzing some additional factors now with some current examples to emphasize my point.
Key factors
Return on equity – This is a critical factor in analyzing a bank. A high ROE is good and low is bad – right? It’s not completely black and white. Other factors being equal (which are listed below), a high ROE is good. However this number has to be looked at in context of CAR (capital adequacy ratio) and quality of assets (NPA number). Most of the top banks such as HDFC, Axis etc have an ROE in excess of 20% or higher.
An additional number to look at in conjunction with ROE is ROA (return on asset). A number in excess of 1.3% is generally good.
CAR – This is the ratio of equity to risk weighted assets. The RBI has a guideline on the minimum CAR ratio for a bank and if the CAR ratio falls below this number, then the bank has to either raise equity or reduce the assets (read loans) to get the number in line with the guidelines. You can think of this number as fuel for growth – higher the number, higher the amount of loans which the bank can make. In addition a high number also enables the bank to absorb loan losses.
The CAR number for most of the banks has improved in the last few years and banks like HDFC, Axis , Karur vyasa bank (KVB) etc have CAR ratios of around 15% (v/s statutory number of around 9%)
Net or Gross NPA – This number points to the amount of bad loans (interest over due by 90 days) on the bank’s books. A low number is always good. An NPA number (net NPA) of more than 4% is alarming and points to a considerable amount of bad assets. In addition, one can expect the bank to take provisions (keep aside some of the profits) to reduce the NPA
This number has dropped considerably in the last few years for most banks and is as low as 0.2% for banks such as Axis, HDFC bank and Yes bank.
Provision / GPA – This is another key factor to look at from an asset quality standpoint. One can look at this number in conjunction with Net NPA. Provision/Gross NPA tells us how much of the bad loans have been accounted for (profits set aside to write off the loans). A 100% number would mean that the bank has set aside the entire bad loan amount from the profits.
The current guideline from RBI is that all banks need to have a minimum 70% coverage ratio.
Borrowing cost – This is the equivalent of raw material cost for a manufacturing company. A low number is always good. A bank is able borrow money via the savings/current accounts of its customer and through bulk deposits. The savings/ current account generally payout a low interest rate and is the best source of low cost funds for the bank.
An associated number to track for the bank is the CASA ratio (current and saving account/ total deposit). A high and growing CASA ratio, means that the bank has a low cost of funds and is growing this source further.
Banks such as Axis bank or State bank of India which have a high CASA ratio, have cost of funds which is as low as 5%. On the other hand the newer banks such as Yes bank which are still putting their retail network in place have a low CASA ratio of around 10% and a much higher cost of funds. One can expect these banks to keep expanding their network and drive down their cost of funds .
NIM (net interest margins) – This is the difference between the borrowing costs and the lending rate. A higher number is good, but upto a point. A number much higher than industry average can be risky as the bank may be lending to risky borrowers (real estate developers, brokers etc) and may face bad debts at a later date.
This number has seen an improvement in the last few years to around 3% levels for most banks due to a combination of reducing loan losses (NPA) and improvement in cost ratios (operating costs)
NII (non interest income) – This is the non lending type income – think of it as the icing on the cake (in some cases a lot of icing). This includes income from investments (in bonds and government securities), brokerage/ service income from distribution of financial products, income from derivative and forex contracts etc.
There is almost an unsaid assumption, that NII is good and higher the NII, better the quality of the earnings. I don’t agree with this assumption. I prefer to look at the composition of NII. If the non interest income is through trading or through gains in the value of investments, then the quality and sustainability of the earnings is not high.
Next post : More ratios and some non financial factors and how to look at them to develop a composite picture of the bank.
In this post, I will be looking at some key factors in analyzing banks. I have written about banks earlier – see here, here and here. I have covered several factors important in analyzing a bank, in these earlier posts and will be analyzing some additional factors now with some current examples to emphasize my point.
Key factors
Return on equity – This is a critical factor in analyzing a bank. A high ROE is good and low is bad – right? It’s not completely black and white. Other factors being equal (which are listed below), a high ROE is good. However this number has to be looked at in context of CAR (capital adequacy ratio) and quality of assets (NPA number). Most of the top banks such as HDFC, Axis etc have an ROE in excess of 20% or higher.
An additional number to look at in conjunction with ROE is ROA (return on asset). A number in excess of 1.3% is generally good.
CAR – This is the ratio of equity to risk weighted assets. The RBI has a guideline on the minimum CAR ratio for a bank and if the CAR ratio falls below this number, then the bank has to either raise equity or reduce the assets (read loans) to get the number in line with the guidelines. You can think of this number as fuel for growth – higher the number, higher the amount of loans which the bank can make. In addition a high number also enables the bank to absorb loan losses.
The CAR number for most of the banks has improved in the last few years and banks like HDFC, Axis , Karur vyasa bank (KVB) etc have CAR ratios of around 15% (v/s statutory number of around 9%)
Net or Gross NPA – This number points to the amount of bad loans (interest over due by 90 days) on the bank’s books. A low number is always good. An NPA number (net NPA) of more than 4% is alarming and points to a considerable amount of bad assets. In addition, one can expect the bank to take provisions (keep aside some of the profits) to reduce the NPA
This number has dropped considerably in the last few years for most banks and is as low as 0.2% for banks such as Axis, HDFC bank and Yes bank.
Provision / GPA – This is another key factor to look at from an asset quality standpoint. One can look at this number in conjunction with Net NPA. Provision/Gross NPA tells us how much of the bad loans have been accounted for (profits set aside to write off the loans). A 100% number would mean that the bank has set aside the entire bad loan amount from the profits.
The current guideline from RBI is that all banks need to have a minimum 70% coverage ratio.
Borrowing cost – This is the equivalent of raw material cost for a manufacturing company. A low number is always good. A bank is able borrow money via the savings/current accounts of its customer and through bulk deposits. The savings/ current account generally payout a low interest rate and is the best source of low cost funds for the bank.
An associated number to track for the bank is the CASA ratio (current and saving account/ total deposit). A high and growing CASA ratio, means that the bank has a low cost of funds and is growing this source further.
Banks such as Axis bank or State bank of India which have a high CASA ratio, have cost of funds which is as low as 5%. On the other hand the newer banks such as Yes bank which are still putting their retail network in place have a low CASA ratio of around 10% and a much higher cost of funds. One can expect these banks to keep expanding their network and drive down their cost of funds .
NIM (net interest margins) – This is the difference between the borrowing costs and the lending rate. A higher number is good, but upto a point. A number much higher than industry average can be risky as the bank may be lending to risky borrowers (real estate developers, brokers etc) and may face bad debts at a later date.
This number has seen an improvement in the last few years to around 3% levels for most banks due to a combination of reducing loan losses (NPA) and improvement in cost ratios (operating costs)
NII (non interest income) – This is the non lending type income – think of it as the icing on the cake (in some cases a lot of icing). This includes income from investments (in bonds and government securities), brokerage/ service income from distribution of financial products, income from derivative and forex contracts etc.
There is almost an unsaid assumption, that NII is good and higher the NII, better the quality of the earnings. I don’t agree with this assumption. I prefer to look at the composition of NII. If the non interest income is through trading or through gains in the value of investments, then the quality and sustainability of the earnings is not high.
Next post : More ratios and some non financial factors and how to look at them to develop a composite picture of the bank.
November 8, 2007
Financial institutions and risk
update: 09-Nov - A great post on the valuation of financial firms and the diffculty of doing so ...see here
I have written on banking earlier. You can find my analysis of allahabad bank here. Most of you must be aware of the subprime crisis. I discussed it briefly here.
Banks and financial instutions by their very nature are highly leveraged organizations. So the risk of bankruptcy and losses is higher with banks. Citibank is one of the largest bank in the world and has seen its stock drop by 35% this year. The CEO has just resigned. You can read all about the crisis here.
So what does citibank and the subprime crisis have to do with banking in india. Well a lot … Let me digress and tell you a short story.
The year is 1996 or maybe 1997. I was starting to invest and saw an article on IFCI (I guess you must have already got the hint or must be thinking ….what a Bozo !). Well, the article said that IFCI is a good opportunity as it was near its 52 week low and had a dividend yield of almost 5-6 % (don’t remember the numbers exactly). So thinking that I had found a good opportunity I promptly bought some stock.
Fast forward: 1998-1999. IFCI is a government controlled institution. Politicians look at it as their piggy bank. So if you are a well connected businessman, launch a project, get funding from IFCI, take your money out and refer the company to BIFR. So by 1999, I think IFCI had more than 12% NPA and was bankrupt. There was hardly any dividend and the stock had tanked by more than 70%.
So the moral is …..
1. Don’t base your investments on someone else’s analysis
2. Investing based only on dividend yields is not a good idea. Investing in financial institution based only on dividend yields is a very bad idea unless the financial institution is sound and can maintain the dividend.
So what has happened with citibank is possible with Indian banks too. Banks have a lot of leeway in hiding bad loans. Indian public sector banks due to political interference can end up with even more and these bad loans or assets come out only later. It is difficult to judge asset quality just from the balance sheet
Added note: I have an NRI friend who had invested in citibank based on the dividend yield. Just out of curiosity I downloaded the AR of the bank and my head started spining. It is more than 100 pages, very complex and very difficult to understand (especially for me and may be the CEO too who got fired for not understanding or maybe underestimating the risks).
I have written on banking earlier. You can find my analysis of allahabad bank here. Most of you must be aware of the subprime crisis. I discussed it briefly here.
Banks and financial instutions by their very nature are highly leveraged organizations. So the risk of bankruptcy and losses is higher with banks. Citibank is one of the largest bank in the world and has seen its stock drop by 35% this year. The CEO has just resigned. You can read all about the crisis here.
So what does citibank and the subprime crisis have to do with banking in india. Well a lot … Let me digress and tell you a short story.
The year is 1996 or maybe 1997. I was starting to invest and saw an article on IFCI (I guess you must have already got the hint or must be thinking ….what a Bozo !). Well, the article said that IFCI is a good opportunity as it was near its 52 week low and had a dividend yield of almost 5-6 % (don’t remember the numbers exactly). So thinking that I had found a good opportunity I promptly bought some stock.
Fast forward: 1998-1999. IFCI is a government controlled institution. Politicians look at it as their piggy bank. So if you are a well connected businessman, launch a project, get funding from IFCI, take your money out and refer the company to BIFR. So by 1999, I think IFCI had more than 12% NPA and was bankrupt. There was hardly any dividend and the stock had tanked by more than 70%.
So the moral is …..
1. Don’t base your investments on someone else’s analysis
2. Investing based only on dividend yields is not a good idea. Investing in financial institution based only on dividend yields is a very bad idea unless the financial institution is sound and can maintain the dividend.
So what has happened with citibank is possible with Indian banks too. Banks have a lot of leeway in hiding bad loans. Indian public sector banks due to political interference can end up with even more and these bad loans or assets come out only later. It is difficult to judge asset quality just from the balance sheet
Added note: I have an NRI friend who had invested in citibank based on the dividend yield. Just out of curiosity I downloaded the AR of the bank and my head started spining. It is more than 100 pages, very complex and very difficult to understand (especially for me and may be the CEO too who got fired for not understanding or maybe underestimating the risks).
November 2, 2007
Sundaram Finance Spreadsheet
I have uploaded the spreadsheet for sundaram finance in valueinvestor india google group.
Please use link - http://groups.google.com/group/valueinvestorindia to download the file. Please also see the disclaimer, as I am not recommending this stock. The spreadsheet analysis (correct or wrong) is my personal analysis of the company.
You can find the sum of the part analysis of the company under the tab – sum of parts.
Please feel free to leave a comment if you find something wrong in the spreadsheet.
Please use link - http://groups.google.com/group/valueinvestorindia to download the file. Please also see the disclaimer, as I am not recommending this stock. The spreadsheet analysis (correct or wrong) is my personal analysis of the company.
You can find the sum of the part analysis of the company under the tab – sum of parts.
Please feel free to leave a comment if you find something wrong in the spreadsheet.
October 17, 2007
Banking
I have written earlier on banks
On valuation approach of banks
More thoughts on valuation of banks
Various factors to evaluate banks
Margin of safety and Banks
I recently posted on a Financial services company ‘sundaram Finance’ which has a business model similar to banks.
I have been analysing banks as a group, trying to understand their business models better. I found the following articles useful to understand the working of a bank
Asset liability management function of banks
Various factors in evaluating banks
NPA and various factors in understanding Bank NPA’s
A few additional thoughts on the business model of banks
- The traditional lending business of banks is now becoming a smaller portion of the business. The ‘other income’ portion which comes from various activities such as distribution of financial products, cash management etc is now becoming more important as this income is not sensitive to interest rate changes and requires less capital
- The % of other income to total profit is higher for the newer private banks than the PSU banks. In addition lower NPA and more profitable growth has resulted in a higher valuation for private banks such as HDFC, ICICI etc
- Banks have been consistently increasing the proportion of their variable rate products. This enables the bank to reduce their Asset liability mismatch.
- Banks profits, especially of PSU banks were subdued last year due to the increase in deposit rates. However PSU bank assets tend to follow the higher rates with a lag. Private banks are able to manage these fluctuations better through various derivative products. I think PSU banks are still lagging in this field. As a result it is likely that several PSU banks will see an expansion of margins as deposit rates stabilize and the Asset yields improve
- NPA’s in most PSU banks though higher than Private banks are still better than a few years ago
I have done a preliminary analysis of the various banks and have found Private sector banks to be fairly or in some cases slightly over-valued. However there are some PSU banks such as Allahabad bank, which I feel are undervalued. I will be posting on Allahabad bank and a few other banks later.
On valuation approach of banks
More thoughts on valuation of banks
Various factors to evaluate banks
Margin of safety and Banks
I recently posted on a Financial services company ‘sundaram Finance’ which has a business model similar to banks.
I have been analysing banks as a group, trying to understand their business models better. I found the following articles useful to understand the working of a bank
Asset liability management function of banks
Various factors in evaluating banks
NPA and various factors in understanding Bank NPA’s
A few additional thoughts on the business model of banks
- The traditional lending business of banks is now becoming a smaller portion of the business. The ‘other income’ portion which comes from various activities such as distribution of financial products, cash management etc is now becoming more important as this income is not sensitive to interest rate changes and requires less capital
- The % of other income to total profit is higher for the newer private banks than the PSU banks. In addition lower NPA and more profitable growth has resulted in a higher valuation for private banks such as HDFC, ICICI etc
- Banks have been consistently increasing the proportion of their variable rate products. This enables the bank to reduce their Asset liability mismatch.
- Banks profits, especially of PSU banks were subdued last year due to the increase in deposit rates. However PSU bank assets tend to follow the higher rates with a lag. Private banks are able to manage these fluctuations better through various derivative products. I think PSU banks are still lagging in this field. As a result it is likely that several PSU banks will see an expansion of margins as deposit rates stabilize and the Asset yields improve
- NPA’s in most PSU banks though higher than Private banks are still better than a few years ago
I have done a preliminary analysis of the various banks and have found Private sector banks to be fairly or in some cases slightly over-valued. However there are some PSU banks such as Allahabad bank, which I feel are undervalued. I will be posting on Allahabad bank and a few other banks later.
October 2, 2007
The Reliance effect
update : Oct 09
well, the euphoria has increased even more since i posted, which was just a few days back. Reliance and a few other stocks like L&T are the new dotcoms of 2007. I am getting a sense of deja-vu ..can see a replay of 2000 here, alteast the initial part. Soon we will have people justifying the current run-up saying how it is 'different' this time.
Personally, in this bi-polar market i can see quite a few undervalued stocks and would prefer to concentrate on them than get pulled into this frenzy.
The S&P CNX nifty (NSE index) has risen by around 13.2 % in the last one month with the main move happening after the fed rate cut on 18th. The funny thing is that all reliance stocks have shot up since then.
The following is the increase in the price of these stocks in the last one month
RIL – reliance industries – 20.5%
Reliance energy – 75%
RNRL – 115%
Reliance communication – 13.1%
Reliance Chemotex – 147%
RPL – 41%
So I guess anything with the name reliance is in a bull market. The industry does not matter, only the management should be with reliance.
I cannot figure out what is happening. There seems to be two markets now. One is in a bull phase consisting of reliance stocks and a few others, with the rest of the market more or less even. So my approach is to stay away from the overvalued stuff and hold or buy what seems undervalued. Ofcourse i am not into momentum trading, so this approach may not work for those who are into that.
Disclosure – I hold RIL and REL. So I have one portion of my portfolio galloping whereas the rest is barely moving.
well, the euphoria has increased even more since i posted, which was just a few days back. Reliance and a few other stocks like L&T are the new dotcoms of 2007. I am getting a sense of deja-vu ..can see a replay of 2000 here, alteast the initial part. Soon we will have people justifying the current run-up saying how it is 'different' this time.
Personally, in this bi-polar market i can see quite a few undervalued stocks and would prefer to concentrate on them than get pulled into this frenzy.
The S&P CNX nifty (NSE index) has risen by around 13.2 % in the last one month with the main move happening after the fed rate cut on 18th. The funny thing is that all reliance stocks have shot up since then.
The following is the increase in the price of these stocks in the last one month
RIL – reliance industries – 20.5%
Reliance energy – 75%
RNRL – 115%
Reliance communication – 13.1%
Reliance Chemotex – 147%
RPL – 41%
So I guess anything with the name reliance is in a bull market. The industry does not matter, only the management should be with reliance.
I cannot figure out what is happening. There seems to be two markets now. One is in a bull phase consisting of reliance stocks and a few others, with the rest of the market more or less even. So my approach is to stay away from the overvalued stuff and hold or buy what seems undervalued. Ofcourse i am not into momentum trading, so this approach may not work for those who are into that.
Disclosure – I hold RIL and REL. So I have one portion of my portfolio galloping whereas the rest is barely moving.
November 27, 2006
More on Valuation of banks
Got the following comments on my previous post from prem sagar. Thought they were very valid points and hence I am posting my reponse to it seperately in a post.
Hi Rohit,
nice analysis. But I get some thoughts here.
1. What if the bank had been increasing leverage to increase or maintain higher ROE? The bank wud have maintained a 20% ROE, but leverage wud have gone higher and hence the risks. Would you not like to consider higher ROE maintained at stable net interest margins and stable net profit margins in your equation? Paying higher price to book just to maintain higher ROE can be a double edged sword where leverage can be dangerous. Dont we need to maintain our profitability and margin spread too?
Hi Rohit,
nice analysis. But I get some thoughts here.
1. What if the bank had been increasing leverage to increase or maintain higher ROE? The bank wud have maintained a 20% ROE, but leverage wud have gone higher and hence the risks. Would you not like to consider higher ROE maintained at stable net interest margins and stable net profit margins in your equation? Paying higher price to book just to maintain higher ROE can be a double edged sword where leverage can be dangerous. Dont we need to maintain our profitability and margin spread too?
2. What would you pay for a bank/nbfc with a low leverage (Say IDFC with leverage of around 4 times)..that has potential to increase leverage and hence ROE in future...as per your ROE equation, IDFC wud get a low Price to book.
3. Why shouldnt we consider ROA (assets net of NPA) instead of ROE in ur calculation? THis will show if constantly increased leverage was the reason in maintaining ROE or not.
I agree with all the above points. The post on bank valuation is a simplistic approach to valuing a bank. I always consider leverage an important variable expecially for a financial institution, such as a bank. As a matter of fact I tend to avoid companies with high leverage unless they are well run. Businesses with high leverage are extremely dependent on the quality of management. A small error by management can hurt the business very badly (note the number of banks and FI which have failed and been bailed out by the government on tax payers money).
What I should have put in my previous post is that all of the following factors being in favour, ROE can be used as a good variable to value a bank.
Factors
1. Leverage – This is represented by CAR (capital adequacy ratio). Higher the CAR, better the quality of the business. As a personal note, I prefer to select banks with CAR of atleast 10-12%
2. Level of NPA and asset quality. A bank can have high ROE and still have a lot of problems loans which are hidden by a practise called as greening of loans (give loan to an existing account to prevent the loan from defaulting)
3. Level of operating expense / Net interest income. This reflects the operating efficiency of the bank
4. Level of non-interest, fee based income. Higher the better.
5. Brand name, retail network and management quality. All fuzzy factors, but fairly important ones for a bank
I tend not to overwiegh ROA. An ROA of 1.3% or more is good. Acutally a very high ROA may not be a good sign (possible that the bank is lending to high yield, high risk segment)
I also agree with prem’s point that if a bank has a low leverage, then earnings can expand more easily. To put it another way, the bank will have no need to access the capital market to raise equity to fund its growth (one of the problems being faced by several public sector banks).
All said, valuing and analysing a bank is far more diffcult (according to me) than other businesses. However the ROE approach can be taken as one approach to arrive at an estimate of intrinsic value. I acutally use this instrinsic value as a starting point and then adjust this number based on the other factors, after the bank meets the basic quality standards
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