Private Banks India Peer Comparison

Private Banks in the Banking sector in India of late, have seen some compelling valuations. Like me, if you are looking to identify the best pockets of value, (and you like a particular stock, let's say an Axis Bank), an important step to follow is a quick peer comparison against the most important metrics for analysing bank stocks. Let's see how the private banks peer comparison throws up the best and the worst managed! For good measure, I have deliberately included a PSU Bank, State Bank of India!

Strong Capital Base

A strong capital base is the number one issue to consider before investing in a lender

Almost all the private banks managed to raise adequate funds in 2007 and thus maintain Capital Adequacy ratios in FY08 much above the mandatory 9 percent stipulated by RBI. None of the banks seem to be very highly leveraged either, with SBI being on the higher side. (An average bank has a Financial Leverage of 12x as compared to 2x or 3x for a company)

However the NPA (Non Performing Assets) levels tell a story. ICICI Bank stands out with the poorest record on NPAs, and given the overall deteriorating credit quality scenario (due to the slowing economy), gives cause for concern. On the flip side, Yes Bank in particular, Axis Bank, and HDFC Bank are managing NPA levels nicely.

Return on Equity (RoE) and Return on Assets (RoA)

These metrics are the defacto standards for gauging bank profitability. Generally investors should look for mid to high-teen returns on equity. It is easy to boost bank's earnings in the short term by under-provisioning or leveraging up the balance sheet, which can be unduly risky over the long term. For this reason, it is good to see a high level of return on assets as well. For Banks a top RoA is in the 1.2 to 1.4 percent range

There are only three levers for boosting ROE -Net Margin, Asset Turnover and Financial Leverage. Again among all the private banks, ICICI Bank has the poorest record. As we can see it is the dismal net margin (~5% ) that has resulted in such poor Return on Equity (~8%) and Return on Asset (~0.7%) ratios. Again Yes Bank shines bright with the best RoEs and the best ROAs followed by HDFC Bank, closely followed by surprisingly, State Bank of India.

Efficiency Ratio

The efficiency ratio or cost to income ratio, measures non-interest expense, or operating costs, as a percentage of income. Basically it tells you how efficiently the bank is managed. Many good banks have efficiency ratios under 55% (lower the better)

Again Yes Bank presents the best record on cost-efficiency among the private banks. What is remarkable is the way Yes Bank has shown significant improvement in cost-efficiency levels over the years. From a high of 83% in FY06, Operating costs as a percentage of Total Income has progressively come down, year on year, to 29.5% in FY08. State Bank is the biggest surprise here, coming second at ~36%, with Axis Bank following closely behind.

Net Interest Margins (NIM)

Another simple measure to watch is net interest margin, which looks at net interest income as a percentage of average earning assets. Track margins over time to get a feel for the trend.

This is where HDFC Bank's (NIM 4%) record is unmatched. Reason why, it is valued so highly. A consistently high NIM of over 4% for several years takes some doing, especially in the rising interest scenario that we witnessed in the last few years. What is also notable is how Net Interest Income as a percentage of Total Assets has improved over the years.

Axis Bank comes a creditable second, followed by no more a surprise, right - State Bank of India.

Strong Revenues

Historically many of the best-performing bank investments have been those that have proven capable of above-average revenue growth

Yes Bank has been growing at a scorching pace for the last 4 years, albeit on a much smaller base. This shows in the overall growth track record of over 225 percent CAGR over 4 years. What is also commendable is that Interest Income as a percentage of Total Assets has been steadily rising. FY08 levels are at 7.72% beating HDFC Banks 7.6%.

Other private banks like HDFC Bank and Axis Bank have maintained a very decent growth rate in excess of 40%. ICICI Bank has also clocked a growth rate of over 44%. However that growth has come at the cost of rising NPAs and declining margins and profitability.

Price to Book

Because a bank’s balance sheets consist mostly of financial assets with varying degrees of liquidity, book value is a good proxy for the value of a banking stock. Also many of the assets included in their book value are marked-to-market –in other words they are revalued every quarter to reflect shifts in the marketplace, which means that book value is reasonably current. So the base value for a bank should be the book value. Any premium over that, investors are paying for future growth and excess earnings. Typically big reputed banks trade at 2x to 4x book value.

Yes Bank is currently (Mar 24, 2009) trading at 1.09 Book Value, historically at its lowest levels in the last 4 years. Similarly on a price-to-earnings measure too it is quoting at 5x TTM earnings, again historically the lowest levels in 4 years. State Bank of India too is quoting at 1.07x Book Value.

It is significant to note that the two banks - Yes Bank and SBI - have the best RoE record of 18.34% and 16.78% respectively. With low P/B relative to their peers but with the highest RoEs, Yes Bank and SBI are potential bargains, but we will want to do some gold digging. P/BV and RoE have a very strong correlation for Bank stocks as mentioned in -

1. Valuing Financial Services Firms Fig 216, pp 37-38 and
2. The Five Rules for Successful Stock Investing, Valuation -The Basics chapter, pp 130-131

While we need to dig deeper to make sure, It is promising to see that Yes Bank in particular, and State Bank too, has impressive records on some of the most important metrics for bank stocks, as we have seen from the above private banks India comparisons.

Overall verdict

There might be some big concerns on derivative exposures and other contingent liabilities, that is not reflected in this snapshot. However, Yes Bank and SBI are definitely worthy of detailed scrutiny, as both seem to be good bargain prospects.