There are an endless number of metrics one can use to pick a bank stock. But none is more important than the efficiency ratio.
Calculated by dividing operating expenses by net revenue, this ratio tells you how much it costs to produce each dollar of revenue. A ratio of 45% means it costs $0.45 to produce $1 in revenue. A ratio of 75% means the same $1 in revenue costs $0.75 to produce.
Another way to look at it is that the efficiency ratio reveals how much revenue will be left over to pay taxes and distribute to shareholders via share buybacks and/or dividends. A lower ratio means that more revenue flows through to the bottom line. A higher ratio means less is available to pass on to shareholders.
It's probably obvious that the objective is to identify banks with low efficiency ratios. And it's with this in mind that I created the following list, which sorts the nation's biggest publicly traded banks according to how efficient they were in the latest quarter:
As you can see, the five most efficient banks on the list are New York Community Bancorp, US Bancorp, Wells Fargo, Fifth Third Bancorp, and M&T Bank. Not coincidentally, with the exception of Fifth Third Bancorp, these are also some of the best performing stocks over the last few decades.
Since the beginning of 1994, all four have handily outpaced the broader market. New York Community Bancorp led the way with a total return of 3,090%. US Bancorp came in second, at 1,920%. Wells Fargo was third, at 1,390%. And M&T Bank rounded out the list, at 1,260%. Meanwhile, the total return on the S&P 500 was a comparatively meager 542%.
It's worth noting, moreover, that the relationship between high returns and a low efficiency ratio goes beyond the obvious. Namely, because banks with lower ratios are innately more profitable than their less efficient peers, the former have less incentive to stretch for yield by underwriting dubious loans.
As Columbia business school professor Charles Calomiris explained in relation to the financial crisis (emphasis added): "Given an environment in which risk-taking with borrowed money was considered normal, it is easy to understand why some bankers, particularly those who were having trouble competing against more efficient rivals, decided that the right strategy was to throw caution to the wind."
The point here is that the efficiency ratio, while it may be just one metric, is very likely the sine qua nom of great bank stocks.
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John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Apple, Bank of America, and Wells Fargo. The Motley Fool owns shares of Apple, Bank of America, Fifth Third Bancorp, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.