What should investors look for when investing in banks and other financiers?

What should investors look for when investing in banks and other financiers?

Because their entire business - their strengths and their opportunities - is built on risk, it's a good idea to focus on conservatively managed institutions that consistently deliver solid - but not knockout - profits.  Here's a list of some major metrics to consider.

Strong Capital Base

A strong capital base is the number one issue to consider before investing in a lender.  Investors can look at several metrics.

• The simplest is the equity to assets ratio; the higher, the better.  The level of capital should vary with each institution based on a number of factors including the riskiness of its loans.  Most of the bigger banks have capital ratios in the 8% to 9% range.  
• Also look for a high level of loan loss reserve relative to nonperforming assets.

These ratios vary depending on the type of lending an institution does, as well as the point of the business cycle in which they are taken.

Return on Equity and Return on Assets

These metrics are the de facto standards for gauging bank profitability.  

Investors should look for banks that can consistently generate mid- to high- teen returns on equity.  

Ironically, investors should be concerned if a bank earns a level not only too far below this industry benchmark, but also too far above it.  After all, many fast-growing lenders have thrown off 30% or more ROEs, just by provisioning too little for loan losses.  Remember, it can be very easy to boost bank's earnings in the short term by under-provisioning or leveraging up the balance sheet, but this can be unduly risky over the long term.  For this reason, it's good to see a high level of return on assets, as well.

For banks, a top ROA would be in the 1.2 % to 1.4% range.

Efficiency Ratios

The efficiency ratio measures non-interest expense, or operating costs, as a percentage of net revenues.  

Basically, it tells you how efficiently the bank is managed.  Many good banks have efficiency ratios under 55% (lower is better).

Look for banks with strong efficiency ratios as evidence that costs are being kept in check.

Net Interest Margins

Net interest margin looks at net interest income as a percentage of average earning assets.

Virtually all banks report net interest margins because it measures lending profitability.  

You'll see a wide variety of net interest margins depending on the type of lending a bank engages in, but most banks' margins fall into the 3% to 4% range.  

Track margins over time to get a feel for the trend - if margins are rising, check to see what's been happening with interest rates.  (Falling rates generally push up net interest margins.)

In addition, examine the bank's loan categories to see whether the bank has been moving into different lending areas. For example, credit card loans typically carry much higher interest rates than residential mortgages, but credit card lending is also riskier than lending money secured by a house.

Strong Revenues

Historically, many of the best-performing bank investments have been those that have proven capable of above-average revenue growth.  Wide margins have generally been elusive in a commodity industry that competes on service quality.  But, some of the most successful banks have been able to cross-sell new services, which adds to fee income, or pay a slightly lower rate on deposits and charge a slightly higher rate on loans.

Keep an eye on three major metrics:
(1) net interest margin,
(2) fee income as a percent of total revenues, and
(3) fee income growth.

The net interest margin can vary widely depending on economic factors, the interest rate environment, and the type of business the lender focuses on, so it's best to compare the bank you're interested in to other similar institutions.  Fee income made up 42% of bank industry revenue in 2001 and has grown at an 11.6% compound annual rate over the past two decades.  As always, examine the number over a  period of time to get a sense of the trend.

Price to Book 

Because banks' balance sheets consist mostly of financial assets with varying degrees of liquidity, book value is a good proxy for the value of a banking stock.

Typically, big banks have traded in the two or three times book range over the past decade; regionals have often traded for less than that.

A solid bank trading at less than two times book value is often worth a closer look.  Remember, there is almost always a reason the bank is selling at a discount, so be sure you understand the risks.  On the other hand, some banks are worth three times book value or more, but we would exercise caution before paying that much.


The Five Rules for Successful Stock Investing
by Pat Dorsey


Summary:

Equity to assets ratio (capital ratio):  8% to 9% or greater
Loan loss reserve:  High level of loan loss reserve relative to nonperforming assets.
ROE: mid- to high- teen ROE
ROA:  1.2% to 1.4% or higher
Efficiency ratios = (noninterest expense or operating costs)/(net revenues):  < 55% (lower is better)
Net Interest Margins = net interest income / average earning assets:  3% to 4% range
Strong above-average Revenue growth: Look at net interest margin + fee income as percentage of total revenue + fee income growth
Price-to-Book:   Big banks often trade at P/B 2 x  to 3 x range.