With so many issues impacting the ‘bankability’ of ASX banks, Azzet has run a rule over what you need to know when evaluating their performance and future upside.
While the big four banks had a bonanza year in 2024 - collectively up over 28% – due in part to the rotation out of mining stocks, the market is now wary of what’s in store for them this year.
With bank stocks now looking expensive - trading at a 30% premium to their three-year average - the market expects the ‘drab-four’ to start giving back last years’ gains in 2025, especially if there’s a rotation back into the materials sector.
Unsurprisingly, given that the banking sector has never outperformed for two consecutive years - after a strong previous 12 months of more than 15% - brokers have derated banks to Sell or at the very best Hold.
However, it’s worthwhile to note that many analysts who had previously called time on the banks have ended up looking foolish.
Can history repeat?
Historically, banks have outperformed the market by more than 20% after the Reserve Bank (RBA) cut rates. But Citi expects banks to experience greater pressure if credit growth slows, which tends to be the case when central banks ease rates.
However, Macquarie is more bullish about pre-provision earnings growing between 1% and 5% this financial year on the back of favourable margin trends and solid volume growth.
With banks delivering half-year or quarterly earnings updates in mid-February, there’s no better time to get your head around what makes bank stocks tick and how they differentiate from regular stocks trading on the ASX.
What you need to know
To understand how banks are valued in the first place, you need to recognise how they differ from other types of stock.
For starters, unlike regular industrial stocks, banks make money by borrowing, lending and aiding the flow of money throughout the economy. This makes them highly vulnerable to the economic cycle, and as an investor you need to know when they're in or out of the money.
You need to tread carefully when using a price-to-earnings ratio (P/E) and dividend yield to gauge how attractive ASX bank shares might be. That's because bad debts or one-off items can compromise the sustainability of bank dividends.
It's also important to understand that banks require some peculiar evaluation criteria when it comes to assessing their value and business performance. If you do want to use the P/E ratio to help value and compare one bank share against another, then it must be used alongside some bank-specific financial ratios.
While some valuation principles are equally applicable to all companies, there are a number of complications specific to banks. These include determining leverage – due to being both borrower and lender – regulatory impact, capital expenditure and interest margins.
Key financial indicators
Net interest margin (NIM): A bank's primary income source is the difference between interest income from its loan book and interest paid out to depositors. Typically expressed as a percentage of the average loans outstanding over the period under review, this is known as 'net interest margin' (NIM). A high ratio indicates bank efficiency. While you won't find it on official financial statements, most banks disclose this average somewhere near the front of their detailed annual reports.
Cost to income ratio: Measures a bank's operating expenses as a percentage of its total income. The lower the ratio, the better the bank is at controlling costs and most brokers prefer banks with a cost-to-income ratio of less than 50%.
Bad debt ratio:Measures a bank's provisioning for when a client can't meet their repayments and a debt goes bad. The higher the number of bad loans, the higher you really want the net interest margin to be, otherwise it could wipe out a hefty chunk of profit.
Return on assets: As a useful efficiency measure for banks, ROA indicates how profitable a bank is relative to its total assets. Calculated by dividing annual earnings by its total assets, ROA is displayed as a percentage – the higher the better – and should reveal how competent management is at using its assets, like mortgages to generate earnings.
Tier 1 capital ratio: Is a litmus test of a bank's capital strength. It's arrived at by isolating the amount of 'tier 1 capital' – the highest quality capital – then identifying the proportion of 'risk-weighted assets'. Capital ratios in the big four and Macquarie typically range between 10.8% and 12.2%.
Price to book ratio: Is the value you would see if the business was liquidated and liabilities paid out. A ratio of 1 indicates shareholders can only expect a return of book value. A ratio above 1 indicates the extent to which shareholders are potentially exposed to market risk.
While you can find all of these ratios in a bank’s financials, the trick is to know where to look.
Results to watch out for
Half-year results
• Commonwealth Bank: 12 February.
• Bendigo and Adelaide Bank: 17 February
• Judo Bank: 18 February.
Quarterly updates
• Westpac on 17 February.
• NAB on 19 February.
• ANZ YTBD.
