Saturday, 20 June 2009

How to assess a banking stock

Nett Interest Income
- Loan Loss & Prov.
+ Non-Interest Income
Net Revenue
- Non-Interest Expense
Profit Before Tax
Profit After Tax (Earnings)

How well is the bank managing these risks: interest rate risk, credit risk and liquidity risk?
Is the bank conservatively managed and consistently delivering solid but not knockout profits?

Get a feel for,
  • the kind of lending they do,
  • the way that risk is managed,
  • the quality of management, and
  • the amount of equity capital the bank holds.

Here's a list of some major metrics to consider:
1. Strong Capital Base
2. Return on Equity and Return on Assets
3. Efficiency Ratios
4. Net Interest Margins
5. Strong Revenues
6. Price-to-Book

Find the answers to the following questions before investing into a banking stock:

What is the bank's capital ratio (equity-to-assets ratio)? Compare this to the industry average.

What is the level of loan loss reserves relative to non-performing assets?

Is the ROE in the mid to high-teen?

Is the ROA in the 1.2% to 1.4% range?

Is the efficiency ratio (non-interest expense/net revenues) under 55%?

What is its net interest margin (net interest income/average earning assets? (Most banks' margin fall into the 3% - 4% range. )

Track the net interest margins and ask what is the trend? Is it rising? If yes, why?
  • Is falling interest rates pushing up net interest margins?
  • Examine the bank's loan categories. Is the bank moving into different lending areas pushing up net interest margins?

What is the revenue growth? Is this above-average revenue growth?

  • Is this revenue growth due to growth in the non-interest income (fee income)?
  • What is the percentage of fee income to the net revenue? How fast is this growing? (Fee income made up 42% of bank industry revenue in 2001 and has grown at an 11.6% compound annual rate over the past 2 decades.)
  • Is this revenue growth due to growth in interest income? Is this due to paying slightly lower rate on deposits and charging slightly higher rate on loans?

What is the book value of the bank? What is the Price-to-Book ratio? (The base value for a bank should be the book value. For any premium above that, investors are paying for future growth and excess earnings. Typically, big banks have traded in the 2x or 3x book range over the past decade; regionals have often traded for less than that.)

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