Drivers and risks associated with a bank’s share price

Growth in individual sectors of an economy such as resources, finance, banking, retail, and healthcare drive the economic growth of the country. How an economy’s banking sector is performing gives a strong indication of where the economy is headed.

The share price of a bank is influenced by similar factors that influence the price of any other listed company. These factors include demand and supply of products, the industry performance, and steps taken by the government, among others.

However, some essential factors which affect the price of bank share include sentiments of the market, the demand of banking-related services, outlook or future statement of bank, and fundamental valuations, among others. Unlike the sectors specified above, the activities of a central bank play a substantial part in the share price of banks.

How general valuation factors impact the share price?

While doing valuation, an investor uses numerous tools to assess the value of a share. Valuation is primarily for those who believe in fundamental analysis for deriving or finding the value of a stock, whether it is fairly valued or not. However, the primary goal is to find whether the stock is undervalued or overvalued.

The valuation must represent the health of the company, along with its future growth potential. When it comes to banks, this means whether the underlying bank can make good loans, as well as receive interest payments with relative ease.

There are a lot of valuation factors to drive share price, which are used by analysts and investors worldwide. Some of them are:

• Growth of the Bank
• Associated Risks
• Earnings and Returns Scenario (Fundamental Valuation Tools)

Growth of the Bank

This is a fundamental concept which includes the growth in topline and the bottom line. Every investor looks for those signals, which also indicate growth potential in the foreseeable future. To assess a bank’s growth, a review of the annual report with a quarterly statement is performed by the investors, wherein, they compare bottom line growth against the topline growth. Payment of regular dividend also has a significant role as many investors look for the same. However, most of the banks pay a decent amount of dividend in order to retain shareholders.

Apart from these fundamental factors, growth and profitability of banks get influenced by the decision of monetary policy committees and changes in interest rates.

Associated Risks

Risks in a stock market that are the same for all the public companies include volatility, short-term speculation, inflation, currency exchange rates, fear and greed. However, for banks, there are some exceptional risks mentioned below:

• Interest Rate Risk
• Counterparty Risk
• Regulatory Risk

Interest Rate Risk: Health of asset and liabilities of banks are sensitive to change in interest rates. Every bank has the same common objective, i.e. increase the amount of interest, which they generate from the loans they provide and decrease the amount of payable interest on deposits. This is because deposits act as a liability for banks and loans are assets for banks. Keeping in mind that the central banks work more in favour of the common man, if the apex bank decreases the interest rate, there would be a direct impact on the asset.

Counterparty Risk: Counterparty risk is the direct reflection of Non-Performing Assets (NPAs). This risk will only arise when the debtor it transacts with defaults on the payment of loan amount. As a result, there is an increase in NPAs on the balance sheet. As a precautionary measure to safeguard itself from such risks, banks generally take an asset as a pledge while providing a loan.

Regulatory Risk: Concerning the regulatory risks, investors tend to have different opinions. While some investors believe authorities always work in favour of banks, others do not rely on the same and feel it’s the opposite way. In a boarder sense, it can be said that the price of bank share is sensitive to the changing influence of the government.

Earnings and Returns Scenario (Fundamental Valuation Tools)

While investing in bank stocks, an investor should have an eye on some fundamental valuation tools such as:

• Price to Earnings
• Price to Book
• PEG Ratio

Price to Earnings: Price to earnings ratio generally means how much an investor needs to invest in order to get a single penny as a return from the stock. The companies which possess a higher P/E ratio usually have a higher share price. A higher P/E ratio also reflects that investors have great expectations from the company.

Price to Book: In order to find a stock at a low price and assess whether there is a buying opportunity, most of the investors look at Price to Book value ratio. While evaluating Price to Book value, investors also look at the possibility to trade at an improved price in the future.

PEG Ratio: When an investor is not convinced with the price to earnings metric, another step exercised is evaluating the PEG ratio. This ratio reflects the historic growth of a company’s earnings. Lower PEG ratio is the best indicator of future estimated earnings.

Apart from the all above-stated factors affecting bank share price, Dividend Yield can also be considered as a fundamental factor, which can impact the price of a bank share. If any bank decreases the dividend amount due to any financial downturn, it impacts the confidence of an investor and affects the share price. However, falling share price leads to an increase in dividend yield, and this creates a conflict while seeing dividend yield as a factor impacting the share price of the bank.