Banking stocks are one of an investor’s best friends when it comes to dividend investments. Most Malaysia banks are listed on the Bursa Malaysia stock exchange, hence giving the opportunity for investors to become owners and shareholders to a particular bank.
A bank’s primary business is to borrow money from someone and lend it to another person. Thankfully, banks do not need to go around borrowing money from us as most of us automatically keep our money in banks, mostly in the form of a Current Account or Savings Account (CASA). With the money safely entrusted in the hands of the bank of your choice, the bank will lend the money to someone else who needs to finance a purchase, be it an individual who is looking to borrow money for a new car purchase, or a new house purchase. It can also be a company seeking for borrowings to finance a line expansion or for other business purposes.
Not to worry though, all banks reward their account holders with monthly interest. Generally, when banks lend money to those who need it, it will expect a monthly repayment of a loan principal PLUS interest. With the interest earned, the bank will use it to pay off its expenditures, overheads and also a small part of it to CASA holders as a small gesture for borrowing the money to them in the form of interests!
So a banks main revenue seems simple to understand right? But is that all you need to know prior to investing in a banking stock? What else do you need to know before putting your hard-earned money into buying a banking stock?
Here are 10 things you need to check before buying a banking stock
1. Check historical operating revenue
All banks earn money. But a smart investor would want to buy into a bank that has a good track record of growing its revenue. Because the faster and more a bank earns money, the more profits it tends to generate. And that means more profit attributable to shareholders
2. Check historical operating profit
Higher revenues do not really translate to higher profit. Cost and expenditure sometimes increased in tandem or more if not managed properly. A great bank is able to increase its operating profit by increasing its revenue but also controlling its expenditure
3. Check earnings per share (EPS)
When an investor buys a share of a bank, he automatically becomes an owner of it (albeit a small one). Being the owner of a bank, we have a “claim” on the bank’s profit or cash. An investor’s ownership % of a bank is calculated by the number of shares he has on hand over the Net Weighted Average Outstanding Shares of a bank or company. In some circumstances, banks may undergo additional financing activities to raise more capital to fund for expansion or to pay down debts if it faces a tight cash flow situation. Banks may sell additional shares under Rights Issue or Private Placement, which may increase the Net Weighted Average Outstanding Shares, hence potentially diluting the Earnings Per Share (EPS), if the earnings do not grow more than the planned addition of outstanding shares.
4. Check the Capital Adequacy Ratio (CAR)
The Capital Adequacy Ratio (CAR) is a KPI set by the Basel Accords, issued by the Basel Committee on Banking Supervision. Basically, the Basel Accords set recommendations on regulations for the banking industry.
The latest accords, Basel III was enacted to be implemented as a test to a bank’s capital adequacy, stress testing and market liquidity risk. The criteria subject the bank’s financials to test, ensuring that a bank does not risk being run and cease operation
Under Basel III, the minimum capital adequacy ratio that banks must maintain is 8%. So check that a bank’s CAR ratio is at least 8% plus a 2.5% buffer to minimize the risk
5. Check the Cost to Income Ratio
As mentioned previously, a bank can only generate more profits if it keeps its cost checked. Cost to Income Ratio measures the % of the cost that takes up the gross income of a bank.
6. Check other Income Streams
Although a banks primary business is quite foolproof – to borrow money and lend money, earning the interest spread, it must also look into multiple ways to grow its business and create more value to its shareholders!
Some other businesses that a bank usually also participates are investments, stock brokering, issuing of funds, insurance and many more. Check to see if a bank’s revenue stream are plenty and are increasing YoY.
7. Check the Industry & Sector Exposure
Although banking stocks are relatively stable, every now and then we might see the prices subjected to some volatility. Banks are sometimes judged by the customers it lends money to. Example when crude prices are depressed, Oil and Gas companies (O&G) might not perform that well, which may impact their capability to pay back loans and interests to banks.
Check to see if a bank’s exposure to a certain risky industry is higher than normal or skewed.
8. Check the Cash Flow Statement and Non Performing Loan (NPL) ratio
Cash is the life stream of a bank. A bank has to ensure money lent out to borrowers can be successfully collected back with interests. That enhances a bank’s capability to further lend more or invest into ways to make its operations lean.
An investor would prefer a bank that does it due diligence by lending as much money as it can to individuals that are creditable. We can check a bank’s cash flow capability to know whether is it getting more and more cash repayments year on year, and also monitor and compare the NPL ratio to see whether is there an uptick in non performing loans.
9. Check the Valuation of The Price
Great! If you are happy with the bank’s financials and balance sheet strength, it is always best to know what is a good price to buy into the stock. Common stock valuation methods incldue the Price to Earning Ratio (P/E), Price to Book value (P/B), Dividend Yield (D/Y)
10. Check Info for Multiple Banks
Well done! You finally completed a brief yet effective study on a banking stock’s fundamentals and valuation. However, what are the yard sticks that determine how good is good, or how bad is bad?
A good way to determine this is to do a peer to peer comparison of one bank against another bank. That way, by having a set of data and info, you can compare what the strengths and weaknesses of a particular bank against another bank. Information on multiple banks provides an investor better hindsight into choosing the most likely best performing banks at the best price.