With banking stocks making a comeback, I got a lot of queries on potential investment opportunities in this space. Let me know in comments section below if you agree with me on this:

For a well diversified equity portfolio, you should own financial services stocks with a weight-age of at least 30% (in the current market scenario). This is in line with the weight-age of financial services stocks in the Nifty 50 which stands at ~ 31%. See here.

The article below examines 5 banking stocks hand-picked based on key performance metrics.

Note: Use of the word ‘Top’ is not based on market capitalization or profitability, if at all it indicates my personal bias.

[1] CAGR of Top 5 Banking Stocks

• 2005 & 2010 prices as of 20^th October for each year.

% Change in Stock Price

[2] Industry-Wise Distribution of Credit Exposures For Each Bank

Credit exposure include term loans, working capital facilities (i.e. funded facilities like cash credit, demand loans, temporary limits and non-funded facilities like letter of credits, acceptances and guarantees).

[3] NPA and GNPA

[4] Current P/E over 5 Year P/E

1. Kotak Mahindra Bank

At the current price of Rs. 655.30 (price for – 20 October 2015), Kotak Bank’s trailing 12 month PE comes to ~ 41.75 which is a 75% premium to its 5 year average PE Multiple of 23.81.

Axis Bank

At the current price of Rs. 510.30 (price for – 20 October 2015), Axis Bank’s trailing 12 month PE comes to ~ 15.81 which is a 15% premium to its 5 year average PE Multiple of 13.68.

HDFC Bank

At the current price of Rs. 1099.00 (price for – 20 October 2015), HDFC Bank’s trailing 12 month PE comes to ~ 25.95 which is a 11% premium to its 5 year average PE Multiple of 23.25.

Federal Bank

At the current price of Rs. 65.95 (price for – 20 October 2015), Federal Bank’s trailing 12 month PE comes to ~ 12.11 which is a 15% premium to its 5 year average PE Multiple of 10.50.

IDBI Bank

At the current price of Rs. 85.50 (price for – 20 October 2015), IDBI Bank’s trailing 12 month PE comes to ~ 15.17 which is a 95% premium to its 5 year average PE Multiple of 7.77.

Most banking stocks are trading at a premium over their historic PE ratios. Primarily this is because over the past 5 years, stocks were trading low on account of slowdown in the economy and slow growth in earnings. Put differently, the current price earnings multiples are highlighting a positive outlook for the next few years.

FAIR VALUE CALCULATION

The historic 5 year avg of the PE multiple can be used to calculate a fair price for the stock. How this works:

Price/earnings = PE

PRICE/[Trailing 4 quarters EPS] = Historic 5 Year avg. PE

PRICE = Historic 5 Year avg. PE * Trailing 4 quarters EPS

The PRICE you will get this way, will be the fair value of the stock. You can then calculate whether the stock is trading at a premium or a discount over its historic PE.

All this is premised on the assumption that the Price of a stock moves in accordance with its earnings. So as the earnings grow, so does the price; over a longer term, the PE Ratio should remain consistent unless where major changes take place in the business model itself.

See here for an actual calculation of fair value on this basis.

[5] Revenue Break-up

Finally, in terms of revenue streams, some banks get a higher share of revenue from non funded streams.Non-funded revenue (i.e. other income) largely constitutes of fee income such as commission and brokerage fees and client based merchant foreign exchange trade, service charges from account maintenance, transaction banking (including cash management services), syndication and placement fees, processing fees from loans and commission on non-funded products (such as letters of credit and bank guarantees) etc. Growth in other income or non-funded revenue is good for the bottom line (i.e. net profit) as income from this stream is derived without significant mobilization of deposits and hence the cost associated with this income is relatively low compared to interest income. Banks in developed countries derive nearly 50% of their income from these non-funded sources.

At the same time, banks with high Current Accounts & Savings Accounts (CASA) will contiue to earn high net interest margins as interest rate paid on CASA deposits is much lower compared to other deposits like term deposits or recurring deposits. While banks do not pay any interest on current account, interest paid on savings account deposit is set by RBI at 4%. Banks therefore make maximum effort to increase the share of CASA on their books to reduce their overall cost of deposits and increase their Net Interest Margin (NIM). HDFC Bank and Axis Bank have the advantage of a high CASA.

While high CASA is factored in stock prices at all times, going forward, I am of the view that banks with strong non-funded streams will outperform which is why Axis Bank and Kotak Mahindra remain my favorite picks within the banking space.

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Rajat Sharma

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