Why Banks Cannot Be Valued Like Normal Companies

The Usual Toolkit Breaks

For most companies, analysts start with enterprise value, EBITDA and free cash flow. Try that on a bank and every step goes wrong.

Enterprise value adds debt to market cap. For a bank, deposits are debt, and they are many times larger than its equity. EBITDA leaves out interest. For a bank, interest is the business. Free cash flow subtracts capex. For a bank, the real reinvestment is new loans, which are not capex at all.

So banks need a different approach. It starts with a simple idea: for a bank, debt is raw material, and equity is the constraint.

Debt Is Raw Material, Not Funding

A manufacturer borrows to buy machines that make products. A bank borrows, mainly through deposits, to make loans. The deposits are not a way of funding the business. They are the stock in trade.

That is why a bank's debt is usually ten or more times its equity, a level that would be alarming for an ordinary company. It is also why enterprise value makes little sense for banks. Adding deposits to market cap and dividing by an operating profit figure produces a number with no clear meaning.

Equity Is the Constraint

What limits a bank's growth is not cash. It is capital. Regulators require banks to hold equity and other capital against the risk in their loans and other assets.

In India, banks must maintain a minimum total capital ratio of 9% of risk-weighted assets, plus a capital conservation buffer of 2.5%, under the RBI's Basel III rules. Larger, systemically important banks need more.

This changes how growth works. If a bank wants to grow its loans by 15%, it needs roughly 15% more capital. That capital comes from retained profit or from raising new equity. A bank with a high return on equity can fund its growth from profits. A bank with a low return must keep raising capital, which dilutes existing shareholders.

Value From Return on Equity and Book Value

Because equity is the constraint, banks are valued against their equity. The main tool is price-to-book (P/B): market value divided by shareholders' equity.

A simple model links P/B to returns:

Justified P/B = (ROE - g) ÷ (Cost of equity - g)

• ROE is return on equity over the long run.
• g is the long-run growth rate.
• The cost of equity is the return shareholders require.

The intuition is direct. A bank that earns exactly its cost of equity is worth its book value, no more. A bank that earns more is worth a premium. A bank that earns less is worth less than its book.

A Worked Example: Three Banks

Illustrative example. Three banks have a 13% cost of equity and will grow 9% a year over the long run.

Bank A earns four points above its cost of equity and is worth twice its book. Bank C earns two points below and is worth half its book, even though it is profitable. A low P/B on its own does not make a bank cheap. It may simply reflect a low ROE.

Book Value Is Only as Good as the Loans Behind It

Book value assumes the loans on the balance sheet will be repaid. If some will not, book value is overstated.

So analysts adjust book value for bad loans. The key measures are:

• Gross NPAs: loans overdue for more than 90 days, before provisions.
• Net NPAs: gross NPAs minus provisions already set aside.
• Provision coverage ratio: provisions as a share of gross NPAs.
• Stressed loans not yet classified as NPAs, such as restructured loans and loans overdue by 31 to 90 days.

Illustrative example. A bank has book value of ₹10,000 crore and net NPAs of ₹800 crore. If half of those net NPAs will never be recovered, adjusted book value is ₹9,600 crore, 4% lower. At a P/B of 2.0, that is ₹800 crore of market value that rests on loans unlikely to be repaid.

Profit Depends on the Credit Cycle

A bank's return on assets (ROA) is usually small, often around 1% to 1.5% for a well-run bank. Leverage turns it into a much larger ROE:

ROE = ROA × (Assets ÷ Equity)

A bank with an ROA of 1.4% and assets 11 times its equity earns an ROE of about 15%. That leverage cuts both ways. A rise in credit costs of half a percentage point of assets can remove a third of profit in a single year.

This is why bank profits swing so much with the credit cycle, and why a single good year says little. Judge ROE over a full cycle.

Other Things That Matter

• Deposit franchise. A high share of current and savings account (CASA) deposits means cheaper, more stable funding.
• Cost-to-income ratio. Operating costs as a share of income.
• Ownership. Public sector banks have the government as the main owner, which affects capital raising and dividends.
• Accounting rules. Indian banks prepare accounts under RBI prudential norms rather than Ind AS, and the RBI has proposed moving to expected credit loss provisioning, which would recognise expected losses earlier.

Habits for Valuing Banks

1. Use P/B and ROE, not EV and EBITDA.
2. Judge ROE over a full credit cycle, not one year.
3. Adjust book value for net NPAs and stressed loans.
4. Check capital ratios and whether growth will need new equity.
5. Compare CASA share and cost of funds across banks.

The Reframe

A bank is not a company that happens to have a lot of debt. It is a business built on debt, limited by equity and judged by how well it lends. Value it on those terms.