FOOL ON THE HILL
One of the reasons many investors shy away from analyzing banks is that they operate from an entirely separate set of rules than other companies. But an investor who puts some effort into learning the vagaries of financial companies' operations may find that these companies are among the easiest to understand.
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Although banks are generally undercovered by the financial press, they represent some of the best investments in the public marketplace. No bank is going to triple or quadruple your money in a year, but recent events seem to have shown that, well, neither is anything else. Banks are generally stable, heavily regulated, well-capitalized, and -- most importantly -- something we all have experience with. All this combines to make banks very attractive potential investments. Simple, but different While we would generally run from companies with liabilities in the hundreds of billions of dollars, with banks it's just a part of doing business. For this reason, a cash flow statement is generally fairly worthless for bank analysis, and the balance sheet has some peculiarities to it. All told, however, banks have fairly easy financial statements for investors to work with. In conjunction with the scads of earnings that came out of the banking sector for this quarter's "Super Tuesday" yesterday, I'm going to break down a few issues investors should look for and provide some guidelines I use when analyzing these kinds of companies. When looking at bank financials, one would be wise to remember how it is that banks make money. They take risk, and lots of it. It's a core part of the banking business: They use their assets in deposit as the leverage to earn more money than their capital costs. So when you leave money in the bank and are receiving 3% interest, the bank needs to be able to generate a return above that 3% amount, net of costs. This is why banks are so heavily regulated: Even the hint of a capital problem at a bank can cause a run by depositors to get their money out quickly. The best bank investments excel in the following areas: capital adequacy, liquidity, loan quality, capital efficiency, and earnings. Let's use the financial statement of one of my favorite companies: Crazy Woman Creek Bancorp (Nasdaq: CRZY), a local savings and loan from Buffalo, Wyoming. 1. Capital adequacy In order to maintain safety for depositors, the Federal Reserve requires that banks have a minimum ratio of equity to assets of 8%. The Fed and other governmental organizations further define banks as being "well capitalized" if this ratio is over 10%. Essentially, the bank's own equity capital is being used as the safety net. Looking at the balance sheet of Crazy Woman Creek (much as I love typing that name, I'm going to abbreviate it CWC from here on out), we find stockholder's equity of $13.1 million and total assets of $64.8 million, for a ratio of 20.2%. That qualifies it as extremely safe, though it also speaks to the bank's smaller size. Bigger banks will generally maintain lower equity/asset ratios. Investors, though, are advised to stick to banks that qualify as "well capitalized." 2. Liquidity Under no circumstances would an investor -- or a depositor -- want anything to do with a bank without adequate liquidity to meet its withdrawal requirements. In the case of CWC, it has deposits of $32 million and cash and equivalents of $31.5 million, for a ratio of 98.1%. I would be concerned if a bank maintains a liquidity percentage of less than 15%, so obviously CWC has no problems here. Bigger banks will generally have lower ratios than CWC's. Wachovia Bank (NYSE: WB), for example, maintained in 2000 cash and equivalents of $14.1 billion on deposits of $44.4 billion, for a ratio of 31.7%. 3. Loan quality CWC's total loan value is $31 million, and its loan loss reserve is $270,000, for a ratio of .85%. Though low compared to other banks, that is relatively consistent with CWC's operating history. Sure enough, CWC's financials list its non-performing loans as $0. As a small, local bank, CWC's numbers are likely to be much more conservative than those of larger, money-center banks. Investors should watch these ratios quite closely. Banks will generally have non-performing loans of about 1% of their total amount. Although these loans produce no money for the banks, an investor should look for the bank to have at least some non-performing loans, as their absence is a sign that the bank's credit requirements are too stringent. 4. Management efficiency In general, I would suggest that investors should restrict themselves to banks capable of keeping operating expenses at 60% or less. In CWC's case, in 2000 it earned $1.9 million and spent $1.1 million in operating expenses, for a ratio of 57.6%. 5. Earnings In the case of CWC, its ROA for 2000 was a relatively anemic .86%, down sharply from 1999's 1.08%. The culprit for the decline seems to be significantly higher interest expense, as well as rising operating expense. Neither of these is a good thing for CWC shareholders. An investor can look at a bank just as he does his own portfolio. A bank that achieves high profitability but takes inordinate risks to get there may have its place, but those risks must be taken into account. Fortunately, banking almost uniquely lends itself to useful ratios such as those presented above, so an investor can easily see just what risks are involved with any one bank. Investors who want to learn more about this type of analysis should read the excellent Financial Services Glossary produced by the managers of the Drip Portfolio. Fool on! Bill Mann, TMFOtter on the Fool discussion boards Bill Mann wonders if the FCC ever figured out that M*A*S*H slipped some horrendous curse words past the censors, who must not have understood Korean. At time of publishing, Bill did not own any of the companies mentioned, though he is angling for some Crazy Woman Creek Bancorp apparel. The Motley Fool is investors writing for other investors.
Banks have some peculiarities in their financial reporting. For example, although Foolish investors generally look for strong cash positions for their investment companies, cash doesn't mean that much to banks. Oh, they like cash, but banks also tend to carry huge liability accounts, comprised mostly of their customers' deposits.
A bank should hold sufficient capital to support its outstanding loans. Banks run all sorts of probability tests on their loan portfolios to determine the likelihood of default, but at the end of the day these do little to protect the bank, its depositors, or its shareholders if loan losses become severe -- if, for example, a large debtor defaults.
Liquidity is a general measure of how much capacity a bank has to either write loans or meet withdrawals by depositors. For obvious reasons, even if a bank is profitable, it could be in big trouble if it is even perceived to lack liquidity by depositors. As such, investors should make at least a cursory check to ensure that a bank has a sufficient cushion between total deposits and cash on hand.
The above ratio does not assess the quality of the loans a bank holds. A bank can have plenty of capital, but if its loan portfolio is high-risk it can burn through its equity in a hurry in a sudden downturn. Banks are required to maintain a cushion against bad debts, called the loan loss reserve. This number should generally be between 2% and 3% of the total loan value, and more importantly it should be stable from quarter to quarter. Spiraling bad loans and/or loan loss reserves are big warning signs.
Because banks are quite restricted in the types of assets they are allowed to hold, it is fairly easy for investors to compare how well banks perform. The "management efficiency" ratio -- operating expenses divided by net income -- measures how much it costs to run the bank as compared to its peers.
Returns on Assets (ROA), which measures the amount of profit generated on the bank's asset base, is the most important profitability measure for banks. As banks are so capital-intensive, a satisfactory ROA -- defined as net income divided by average total assets -- will range between 1% and 2% per year.
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