Everything an Investor Needs to Know About TD Bank in 1 Quick Read

Over the next month, banks will be releasing results for the second quarter. In advance of these releases, let's take a moment to review the state of some of these banks as of the end of Q1.

Today, we'll look at Toronto-Dominion Bank (TSX: TD  ) , an $832.4 billion bank headquartered -- not surprisingly -- in Toronto and commonly referred to as TD Bank. You can find information on other banks at my Motley Fool article feed, available here. All data in this analysis was sourced from the FDIC's Quarterly Banking Profile and S&P Capital IQ.

When I evaluate banks, I follow a model made famous by former Wachovia CEO John Medlin: soundness, profitability, and growth. As investors, we then look at valuation and the potential for investment after gaining a better understanding for each bank.

Image source: Wikimedia Commons/Matthew Bisanz.

Soundness
Soundness refers to the bank's asset quality. Generally speaking, this means loans. If a bank makes loans that are never repaid, that bank will fail, and fail quickly. The best banks put risk management first, ensuring that shareholder capital is protected if a portfolio of loans turns sour.

To measure this, we'll look at both non-performing assets and Toronto-Dominion Bank's provision for loan and lease losses. A simplified definition of non-performing assets is loans or other assets that have fallen seriously delinquent or are in foreclosure.

The provision for loan and lease losses is a reserve of money that the bank pulls out of its income each quarter to guard against future losses in the loan portfolio. Banks are required by regulation to maintain certain levels of reserves, but within that, management has plenty of wiggle room to over- or under-reserve. Over-reserving increases protection but hurts net income; under-reserving increases risk but keeps net income high.

For the quarter ending on March 31, TD Bank had 0.46% non-performing assets as a percentage of total assets. The FDIC reports that banks with total assets greater than $10 billion on average had 1.47% non-performing assets as a percentage of total assets.

TD Bank reserved $364.0 million for the first quarter, which represented 5.3% of operating revenue. That compares with 5% for the $10 billion-plus peer group, according to the FDIC.

Profitability
After establishing an understanding of a bank's risk culture and soundness, next we can focus on profitability. Any investment in a business is an investment in that company's future earnings, so profitability is a particularly important consideration for any bank investor.

The first question, perhaps most obviously, is whether the bank actually generates a profit at all. According to data from the FDIC, 7.3% of U.S. banks failed to generate a profit at all in the first quarter. That's one in every 14 banks!

TD Return on Equity (TTM) Chart

For TD Bank, the first calendar quarter of 2014 wasn't that bad. The company generated total net revenues of $6.9 billion for the quarter -- that is total interest income plus non-interest income minus interest expense.

Over the past 12 months, The Toronto-Dominion Bank has generated $25.5 billion in total net revenue. Of that revenue, 59% was attributable to net interest income, the difference between interest earned on loans and paid out to depositors. The remaining 41% was through fees, trading, or other non-interest revenue sources.

The bank was able to turn a profit margin of 26% on that revenue, slightly higher than average for large North American banks.

For the first quarter, the company reported return on equity of 15%. Of the banks covered in this series of articles, the average return on equity was 8.9%. The FDIC reports that the average ROE for U.S. banks with total assets greater than $10 billion was 9.1%.

Clearly, TD Bank is doing something right on the profitability front. The company is churning out margins and returns better than its peers.

Circling back for a moment to the bank's soundness profile, it's comforting to know that the bank does have the income-generating engine to increase reserves as needed without denting the income statement in any noticeable fashion. But profit margins can be erased almost instantly by bad loans; this comfort is at best a mitigation and by no means a solution.

Leverage
Leverage is a double-edged sword for banks and could easily fit into either the soundness or profitability categories. We'll call it a subset of both and discuss it here.

Leverage is just part of the game with banks, so if you're a conservative investor who really focuses on conservative capital structures, the banking industry may not be the best place for your money. Adding leverage is an easy way to juice return on equity, which is, generally speaking, a good thing. The bank increases assets and thus earnings, while maintaining a lower capital level.

The result is a higher numerator, a constant denominator, and a larger return-on-equity number. The math does the heavy lifting for you.

On the flip side, too much leverage can put the bank on thin ice if the loan portfolio takes a turn for the worse. A stronger equity base protects the bank from bankruptcy and bailouts, two outcomes that are both politically charged and downright terrible for shareholders.

Ban's use all kinds of esoteric and overly complex accounting methods to determine leverage. We'll keep it simple here with an old-fashioned assets-to-equity ratio. The lower the number, the less levered (and more conservative) the bank.

TD Bank's assets-to-equity ratio comes in at 16.7. The average of the 62 banks analyzed in this series of articles was 9.1.

TD Assets To Shareholder Equity (Quarterly) Chart

I hope that number stopped you in your tracks. It certainly made me look twice.

At this point, the bank's impressive ROE figure suddenly doesn't look so impressive. To be fair, a bank with 17 or so times leverage in 2005 wouldn't have been shocking at all. However, serious lessons were learned in the financial crisis about the risks of leverage -- risks that TD Bank is apparently willing to take, even with well above peer average non-performing assets.

Growth and valuation
Toronto-Dominion Bank saw its revenues change by 7% over the past 12 months. That compares with the 5.7% average of the 62 banks analyzed.

This change in revenue corresponded with a 6% in net income over the same period. The peer set averaged 14.1%.

Fifty-four percent of all U.S. banks saw year-over-year earnings growth in the first quarter.

TD Chart

Moving now to valuation, TD Bank traded at a forward price-to-earnings ratio of 12.4, according to data form Capital IQ. That compares with the peer set average of 16.7.

Toronto-Dominion Bank's market cap is, at the time of this writing, 3 times its tangible book value. The peer set average was 1.9.

Many investors use a general rule of thumb of buying a bank stock when the price-to-tangible book value is less than 0.5 and selling when it rises above 2. For me, that method is just way too oversimplified.

It sometimes makes sense to pay a premium for a bank stock that places a high value on credit culture and asset quality. These banks will survive and prosper while others fall by the wayside. That security can be worth a premium. Likewise, a bank that relies heavily on leverage to achieve above-average return on equity may not be worth the price, even if price-to-tangible book value is low. That risk may not justify even a healthy discount in price.

Based on the factors we've discussed here -- soundness, profitability, and growth -- I see TD Bank as being overvalued.

The bank has eyebrow-raising leverage and an asset base of questionable credit quality. The bank's impressive earnings and return on equity don't come close to justifying the bank's price-to-tangible book valuation of 3.

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