📚 PASS Research Analyst Certification Examination Difficulty: Beginner ℹ️ Info   ~5 min read
📌 Chapter 3.1 — Terminology in Equity Market

Imagine you are building a valuation model for a major private sector bank in India. You quickly realize that traditional metrics like the Price-to-Earnings (PE) ratio feel incomplete, given the bank’s complex loan book and recurring provisions. In the financial sector, debt is not merely a source of leverage but the raw material of the business itself.

Consequently, the Dividend Discount Model (DDM), specifically the Gordon Growth Model or the two-stage model, becomes your primary tool to discount the expected dividends back to their present value, as free cash flow to the firm is difficult to define for banks.

Because financial institutions deal primarily in monetary assets, their balance sheets are marked to market much more frequently than those of manufacturing firms. This is precisely why the Price-to-Book (P/BV) ratio remains the gold standard for quick valuation checks in the NISM context. Since most of a bank’s assets—loans, investments, and cash—are liquid and subject to valuation adjustments, the book value provides a relatively accurate reflection of the capital deployed.

If a bank’s Return on Equity (ROE) is consistently higher than its Cost of Equity (COE), a P/BV ratio above 1.0 is justified, as the bank is creating value by deploying capital efficiently.

To move beyond the P/BV, analysts often employ the Residual Income Model (RIM). This approach calculates value by taking the book value of equity and adding the present value of future economic earnings, defined as the net income minus the product of equity and the cost of equity.

In the Indian context, where banks have distinct business cycles and regulatory capital requirements under Basel III, the RIM helps distinguish between banks that are merely growing their loan books and those that are generating superior shareholder wealth. By focusing on the surplus value created over the cost of capital, you can avoid the common error of overvaluing banks that expand aggressively but fail to earn their required return.

Consider two banks: Bank A has a P/BV of 2.5 but an ROE of 18%, while Bank B has a P/BV of 1.2 but an ROE of 8%. A novice might mistakenly label Bank B as ‘cheaper’ or a better bargain. However, a seasoned analyst recognizes that Bank A is trading at a premium because it creates significant economic value, whereas Bank B is likely destroying value relative to its cost of equity.

Your recommendation must therefore rest on the sustainability of the ROE and the bank’s ability to manage its net interest margins within the volatile interest rate environment of the Reserve Bank of India (RBI).1

Nuance

⚠️ Nuance
Candidates often fall into the trap of using EV/EBITDA for banking stocks, failing to recognize that ‘Interest Expense’ is a primary operating cost for a bank, not a financing cost. Applying manufacturing-based valuation multiples to banks ignores the inherent nature of financial intermediation. Always prioritize P/BV and dividend-based models (DDM/RIM) to account for the unique capital structure of financial services firms.

Check Your Understanding

Practice Question 1

An analyst is evaluating two banks. Bank X has an ROE of 15% and a Cost of Equity of 12%. Bank Y has an ROE of 10% and a Cost of Equity of 13%. Which valuation conclusion is most appropriate?

Practice Question 2

Why is the Dividend Discount Model (DDM) often preferred over the Discounted Cash Flow (DCF) model for valuing banking institutions?

This is a companion read for Section 3.1 — Terminology in Equity Market from PASS Research Analyst Certification Examination by Akhilesh Gururani, available on Amazon Kindle.

Copyright © 2026 Akhilesh Gururani. All rights reserved.

  1. The cost of equity is typically derived using the Capital Asset Pricing Model (CAPM), reflecting the risk-free rate, beta of the bank stock, and the equity risk premium. ↩︎