PSU bank stocks rally on fund-raising reports

However, given the very compelling valuations currently, we see significant upside for them," said Manish Karwa, analyst, Deutsche Bank.

Public sector banks have delivered higher earnings growth of 22% YoY compared with 17% of private banks in the quarter ended September. PSU banks also saw healthy core profitability growth of 18% versus 9% for private banks from the same period a year ago. "We believe current valuations of PSU banks make them more attractive in the near to medium term and prefer SBI, Union Bank and Bank of India," said Manish Chowdhary, analyst, IDFC Securities.

The return on assets (RoAs) of public sector banks have declined from 1-1.2% to 0.5-0.7% over the last five years, but this decline has largely been due to higher credit costs, lower margins and inferior cost structures.

Analysts expect RoAs to improve to 0.8-0.9% but return on equity (RoE) will remain in the 12-15% bracket and capital requirement will remain large.

"While loan growth is likely to remain modest, lower interest rates in the medium term could be positive for earnings, especially for public sector banks," said Chowdhary.