Choosing a Bank Stock: 3 Key Metrics

"I had nothing to offer anybody except my own confusion." -- Jack Kerouac

When it comes to banks, I'm about as confused as anyone. However, that is precisely what I have to offer, because for many of us, analyzing banks can be pretty darn confusing, and that means we need to start from the beginning.

Our challenge is clear: Together we'll learn how to evaluate banks well enough to invest in one -- not run one -- and that's exactly what we'll stick to. And we'll start with the three most important metrics when analyzing a bank:

  1. Net interest margin (NIM)
  2. Nonperforming loans
  3. Capital ratio

Today, we'll dig in and see how U.S. Bancorp (NYSE: USB  ) -- widely held as one of the more efficiently run banks in the country -- stacks up against other leading U.S. banks in these three key areas.

NIMs the word
Net interest margin (NIM) is one of the most common ways to track a bank's lending and investing profitability. It's done by dividing net interest income -- the difference between revenue created by interest-bearing assets and interest payments on liabilities -- by average interest-earning assets.

In practice, it's most useful when comparing a company to itself over time. For instance, U.S. Bancorp's NIM was 3.88% in 2010, 3.65% in 2011, and 3.58% in 2012.

In comparison, PNC's (NYSE: PNC  ) NIM went up 0.02% to 3.94% from 2011 to 2012, and BofI Holding's (NASDAQ: BOFI  ) NIM has been steadily trending upwards since 2010 -- 3.79% in 2013.

Okay, while U.S. Bancorp's margins are shrinking, and that's never a good sign, NIM alone can't tell us the whole story; for that, we'll have to do some more digging.

Loan performance
In theory, a bank generates revenue by collecting interest on what it lends out. And much of the time, that's exactly what happens, but in some cases, loans never get paid back. This is our game changer, because while the concept of loans not being repaid isn't new, how a bank is able to cut down on these "nonperforming loans" is critical.

Consider again PNC's NIM of 3.94% versus U.S. Bancorp's 3.58%. At a glance, PNC looks to be in better shape; however, 1.75% of PNC's loans are nonperforming, while just under 1% of U.S. Bancorp's loans are nonperforming (including covered assets).

BofI is leading the pack with nonperforming loans of 0.8%.

Ultimately, we'd hope to see improved margins while cutting down on nonperforming loans. And as it sits now, PNC and BofI have been steadily improving both metrics. On the other hand, while U.S. Bancorp's NIM seems to be moving in the wrong direction, it's made up for it by making smart loans.

Capital requirement
This is how much capital a bank should be holding compared to the money it's lent out. The more capital available, the more likely the bank can sustain losses while still covering withdrawals.

There are a number of different capital ratios, but for simplicity sake, we'll use total assets divided by shareholders equity. U.S. Bancorp has $354 billion in total assets and $39 billion in shareholder's equity, giving it a capital ratio of 9.07, down from 10 in 2011.

PNC's ratio went from 7.9 in 2011 to 7.8 in 2012, while BofI's dropped slightly as well, from 10.6 in 2012 to 10.2 in 2013. While there's hope we'll continue to see equity cushions increase, all three companies more than meet the required standard.

Time to invest
All three companies have strong margins, though I would like to see U.S. Bancorp's NIM start growing. Each has proven its ability to make smart loans, and all three have more than met their capital requirements.

However, as much as I'd like to say yes, it's not quite time to invest yet. While financial metrics are a great tool, they're just that, a tool. To feel truly comfortable investing your money in a company for the next 10, 20, or 30 years, we'll need to dig in further. So stay tuned as we continue to crack into U.S. Bancorp while moving forward in our quest to understand banks well enough to invest.

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