Investing in the stock market requires a thorough understanding of the different factors influencing stock prices. And truth be told, there is no easy way to pick stocks to build a diversified portfolio. A sound investment strategy is one of the essential aspects of stock market investing; the best investment newsletters also provide the reader with the latest market news and trends. Most are written by professionals and are free to read. If you are looking to focus on different sectors to have a robust portfolio, banking could one option for you. To pick the best banking companies for investment, you should know how to analyze bank stocks.
How do banks earn money?
Before you choose any stock to buy, it is important to look at their business model. Banks earn money through the following ways:
- Interest on loans
Banks earn a significant share of their income from the interest on the amount they lend, i.e. loans of all kinds.
- Charges on services
Another source of income for banks is the fee charged on a host of services. Fines for overdrafts, non-maintenance of balance, etc., are also a source of income for banks.
- Advisory and complementary services
Banks also offer advisory services (investment, mergers and acquisitions) and services such as insurance, investments in the stock market, mutual funds and bonds. They charge brokerage or fees on these services.
How to analyse bank stocks?
Banks make their financial figures public quarterly and annually. A host of indicators made public can help you choose which stocks to buy today.
Advance Deposit Ratio (ADR)
ADR indicates the ratio of total advances (loans) to a bank’s total deposits and reflects the ability of a bank to use its funds. Hence, look for a bank that has a lower ADR. However, when comparing the ADR of different banks, ensure that they are similar in size and structure.
Return on Assets (ROA)
ROA measures the profitability of the bank. A higher ROA indicates that the bank earns more on lesser investment. Banks generally have a lower ROA value when compared to other industries; however, you should invest in banks with a minimum ROA of 1%.
ROA = Net Income/Total Assets
Return on Equity (ROE)
ROE calculates how efficiently a business generates returns using the funds collected from its investors.
ROE = Net Income/Total Shareholder’s equity
Most businesses focus on earnings per share, but ROE is a better indicator for the banking sector. ROE provides a better indicator of the growth and market worth of banks. If you analyse the stock market today to pick bank scrips, look for an ROE greater than 15%. The higher the ROE, the higher is the profitability.
- Non-Performing Assets (NPAs)
A loan becomes an NPA when it stops generating any income for the bank. Gross NPAs are the total loans classified by the banks as non-performing. NPAs help assess the asset quality of the bank. When you pick stocks to buy, look for banks with lower NPAs.
These are a few ways of analysing bank stocks. You can use other indicators such as the net interest margin, provisioning coverage ratio and equity multiplier ratio to choose which stocks to buy.
Investing in the right products, specifically equity, can help you in wealth creation over the long term. While bank stocks could be one option, there are options like mutual funds that could help you fulfil your wealth creation objective. Before you make any investment decision, it is prudent to consult an expert to ensure that the avenues you choose are your best choice.