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3 Things Investors Should Consider Before Investing In A Bank

The Singapore stock market is home to some of the largest financial institutions in the region such as the banks DBS Group Holdings Limited (SGX: D05) and Oversea-Chinese Banking Corporation Ltd (SGX: O39).

But just because banks here are huge companies does not mean they are automatically good investments. So, what should you look out for when analysing a bank? Here are three things to consider.

1. Leverage

A bank is an inherently leveraged entity – it borrows money from depositors and lends out that capital. The thing about leverage is that it can be a double-edged sword. So, it is very important for a bank to manage its risks conservatively.

All banks in Singapore need to comply with regulations that govern their capital ratios (essentially the amount of cushion for a bank to absorb losses). But, it is also important for investors to see whether a bank has capital ratios that are in excess of the minimal requirements set by the regulators.

2. Non-performing loans

I mentioned earlier that the main business of a bank is to give out loans. As such, the management of risks in its loan approval process is critical to the overall business. This in turn makes it important for us to observe if a bank has been able to maintain its non-performing loans (NPL) ratio at a comfortable level.

To get a handle on that, we can compare how the NPL ratio of the bank we are analysing stacks up with that of its peers. Preferably, we would like the NPL ratio to be as low as possible.

3. The price to book ratio

Valuation plays a big part in determining how attractive a company might be as an investment. And for a bank, the most important valuation tool might be the price-to-book (P/B) ratio. The P/B ratio divides a bank’s share price by its book value per share (total assets per share minus total liabilities per share).

This is because a bank often owns financial assets such as loans, cash, and bonds, which are all relatively simple to value given that they have a market price. Thus, a P/B ratio can be a good proxy to gauge the value of a bank. In theory, we would prefer a bank with a low P/B ratio to one with a high P/B ratio, all things being equal.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn’t own shares in any companies mentioned.