How to analyse bank stocks
A bank borrows money from depositors and lends it out at a higher rate. Its profit is the gap between the two, minus running costs and minus loans that go bad. So you judge a bank on the quality of its loans and the cost of its deposits, not on the usual factory-company ratios.
The numbers that matter
| Metric | What it tells you | What healthy looks like |
|---|---|---|
| Gross and net NPA | Non-performing assets: loans where the borrower has stopped paying, usually for 90 days or more. Net NPA is what is left after the bank has set money aside for these losses. | Gross NPA falling year after year; low single digits is healthy, and net NPA should be a fraction of that. |
| Provision coverage ratio | How much of its bad loans the bank has already written off against profit, as a percentage. | Higher is safer; a bank that has covered most of its bad loans has fewer shocks waiting. |
| CASA ratio | The share of deposits sitting in current and savings accounts. These pay little or no interest, so they are the cheapest money a bank can get. | A high and steady CASA share means cheap, sticky funding. |
| Net interest margin (NIM) | Interest earned minus interest paid, as a percentage of the loans and investments that earn interest. | Steady margins over several years matter more than one high quarter. |
| Capital adequacy ratio | The bank’s own capital compared with the risk in its loans. It is the cushion that absorbs losses. | Comfortably above the regulator’s minimum, without frequent fresh share issues to stay there. |
| Return on assets (ROA) | Net profit as a percentage of everything the bank has lent and invested. | Around 1% or more, held steadily, is usually a sign of a well-run bank. |
| Credit cost | New provisions for bad loans in a year, as a percentage of total loans. | Low and stable; a sudden jump is the first sign of stress. |
Why the normal rules break for banks
In the debt lesson you learnt that high debt to equity is risky. For a bank it is the business itself. Deposits are counted as borrowings, so every bank has debt many times its equity. Debt to equity tells you nothing here.
Cash flow is also hard to read. When a bank lends more, its operating cash flow can turn negative, simply because new loans count as cash going out. Do not reject a bank because its cash flow statement looks odd.
Where the profit really comes from
Say a bank takes ₹100 crore of deposits at an average cost of 5% and lends it at 9%. It earns ₹4 crore of net interest. If ₹2 crore of those loans go bad, half of that year’s interest gap is wiped out. This is why loan quality matters more than loan growth.
Banks also earn fees from cards, insurance and other products. Fee income is useful because it does not need fresh capital, but in most banks it is the smaller part of profit.
Growth that is too fast
Loans take a few years to show whether they are good. A bank that grows its loan book much faster than the rest of the industry looks great today, and its bad loans may only show up later. Compare loan growth with the sector and ask what the bank did differently to win that business.
Valuing a bank
Investors usually value banks on price to book value (P/B) rather than P/E, because a bank’s book value is mostly loans and cash. A bank that earns a high ROE with clean loans usually trades at a higher P/B. A low P/B is often cheap for a reason, such as hidden bad loans.
Red flags
- Gross NPA rising for several quarters in a row.
- Loan growth far above the industry while provisions stay unusually low.
- Large exposure to one industry or one group of borrowers.
- Restructured loans growing quietly, which can become NPAs later.
- Capital adequacy close to the regulatory minimum, needing frequent fresh capital.
- Deposits growing much slower than loans, forcing the bank to borrow costlier money.
Common beginner mistakes
- Rejecting a bank because its debt to equity looks huge.
- Treating a low P/B as automatically cheap without checking bad loans.
- Looking only at profit growth and ignoring the provisions behind it.
- Judging a bank on one quarter’s margin instead of a multi-year trend.
Common questions
How do I check if a bank stock is good?
Start with gross and net NPA, the CASA ratio, net interest margin, capital adequacy and return on assets. Look at the trend over at least three to five years, not one quarter.
Why is debt to equity not used for banks?
A bank’s deposits are counted as borrowings, so its debt is always many times its equity. The real risk is bad loans, so you track NPAs and capital adequacy instead.
Is P/E or P/B better for valuing banks?
Most investors use P/B for banks because their assets are mostly loans and cash. Use it together with ROE and NPA levels, since a low P/B can hide bad loans.
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