On a number of occasions, both Matt and I have talked about providing some guidelines on how to evaluate financial companies from a Rule Maker perspective. Back in January, Matt even went so far as to outline some criteria for evaluating these companies. Then, last week, we decided to use our monthly $500 savings in order to pick up a few more shares of American Express (NYSE: AXP).

However, as was mentioned on our message boards, we didn't use that opportunity to touch on how AmEx fares when held to the criteria that Matt presented. As a matter of fact, none of us has ever written a column to demonstrate how these numbers are calculated. So, in light of these facts, I'll use today's report to walk through and explain the essential criteria in evaluating a financial services firm.

I'll be using the numbers from AmEx's 10-Q for the September quarter, as its year-end balance sheet hasn't yet been released. The numbers and methodology that I'm using here should be viewed as being equivalent to a Rule Maker Essentials approach to analyzing financial companies.

1. Sales Growth > 10% -- This one was left unchanged from the sales growth criteria we use to analyze any potential Rule Makers. In the case of financial services companies, however, the definition of revenue (same thing as sales) bears some explaining.

Like most banks, AmEx earns money from two sources: fees and interest. I expect most of us are all too familiar with the fee side of the equation. In bank parlance, this fee income is referred to as "non-interest income." Simple so far. The second revenue source is interest income, which is produced by borrowing money at a certain rate and then lending it out at a higher rate. Thus, it's only the "spread" between the interest earned and the interest paid that can really be thought of as revenue. This spread is called "net interest income." So, our two sources of revenue for a financial services company are non-interest income and net interest income.

Fortunately for us, AmEx's 10-Q income statement nets out the interest expense in presenting its revenues. (If you're not sure how to find this information, all you need to do is read through the notes to the consolidated financials. In the case of AmEx, we can see that the company nets out its interest expense from revenues by reading notes 1 and 5, as well as checking the figures in the income statement.) In the quarter ended September 1999, AmEx had sales of $5,311 billion; sales for the quarter ended September 1998 were $4,787. That's an increase of 10.9%. For the full nine month period through 9/99, revenues grew 10.7%. This level of growth is ahead of both our own Rule Maker target as well as the company's internal goal of 8% revenue growth.

2. Efficiency Margin -- (1 - efficiency ratio) > 20% -- This metric is a substitute for the gross margin calculation used for traditional Makers. The efficiency ratio is non-interest expense divided by revenue. Interest expense is excluded from this calculation due to the fact that for a financial institution it's an expense that's merely part of the cost of doing business. Here are the Q3 '99 numbers for AmEx:

Total Revenue --    $5,311 million
Total Expenses --   $4,404 million
Interest Expense --   $262 million

So, the efficiency ratio calculation -- (4,404 - 262) / 5,311 -- yields a result of 78%. If we subtract this result from 1, then we're left with an efficiency margin of 0.22, or 22%, which is above Matt's target level. This figure is also the same as it was in the third quarter of 1998. AmEx's Efficiency Margin exceeds our target.

3. Net Margin > 7% -- This one was also left unchanged from our traditional net margin criteria. In the quarter ended September 1999, AmEx had net income of $648 million and revenues of $5,311 million. This results in a net margin of 12.2%, which is up slightly from the 12.0% net margin in the third quarter of 1998. Once again AmEx's result is better than our standard.

4. Asset turnover > 0.16 -- Asset turnover is calculated by dividing revenues by total assets. The higher this ratio, the better. It is used as a means of measuring how productively a company utilizes its assets. At the end of the third quarter of 1999, AmEx had total assets of $132,616 million. It had revenues for the quarter of $5,311 million, which we have to annualize for this calculation giving us $21,244. This equates to asset turnover of 0.16. I decided to increase this one slightly from Matt's target of 0.15 because I place great importance on a company's ability to turn its assets over as frequently as possible. AmEx's performance meets our revised target.

One thing to note here is that any time we look at numbers from the balance sheet, we could use average balances over the period that we're analyzing rather than point-in-time balances. In other words, I could take the average of AmEx's total assets at the end of the second quarter and its total assets at the end of the third quarter (we're only looking at one quarter's worth of revenues here). In order to simplify the analysis, I've just gone with the balance at the end of the quarter; however, most times it's viewed as being more accurate to use the average balance for the period.

5. Leverage factor
At the end of the third quarter of 1999, AmEx had total assets of $132,616 million and total shareholders' equity of $9,744 million. This translates to a leverage factor of 13.6. Looks like we have a clean sweep here.

There's one thing that Matt neglected to mention about these last three criteria, that I'd like to point out here. You see, they're actually used as a means of analyzing the components of return on equity (ROE), which goes by the name DuPont Analysis. Let's take a quick look and see how these three metrics can be combined to calculate ROE:

ROE = Net Margin  x  Asset Turnover  x    Leverage Factor  
ROE = Net Income  x      Sales       x      Total Assets       
        Sales        Total Assets       Shareholders' Equity

If you simplify the three equations that I've presented above, you'll see that the sales in the numerator and denominator cancel each other out. The same thing happens with total assets. That leaves Net income divided by Shareholders' Equity, which is also how you calculate return on equity. The theory behind DuPont analysis is that it allows you to gain some insights into what it is that's driving any increment or decrement in a company's return on equity.

Now, let's take the standards that we've set and see what they tell us about our target level of return on equity. If we multiply net margin of 0.07 by asset turnover of 0.16 by leverage of 15, the result is 16.8%, which is thereby our implied minimum ROE. For AmEx, we can multiply 0.122 x 0.16 x 13.6, which gives us a ROE of 26.5%. That's an excellent result.

6. I'd also like to add one final metric here -- the newly minted Cash King Margin (CKM). Our basic target for CKM is 10%, as it should be in excess of net margin. The formula for quarterly CKM is free cash flow for the quarter divided by revenues for the quarter. Let's run through the calculation for AmEx by using this little table:

                           (1)          (2)     (2) - (1)
($ millions)           6 mo. 1999   9 mo. 1999   Q3 1999
Cash from Operations      4,458        6,159      1,701
Net Capital Expenditures   (332)        (525)      (193)
Free Cash Flow            4,126        5,634      1,508
Revenues                                          5,311
Cash King Margin                                  28.4%

As you can see, AmEx had a Cash King Margin of 28.4% for the third quarter of 1999. Translation: The company earned 28.4 cents of cash profit on every dollar of sales. That's outstanding. As a matter of fact, after taking a look at all these numbers, it certainly looks as if AmEx is really clicking on all cylinders right now. A true Finance King.

While we do have to update these numbers for the fourth quarter once the 10-K is released, the fact that our company's stock price has been punished during a time that it's generating these kinds of numbers makes me believe that our decision to add more shares of AmEx this month was a sound one.

Finally, a few Foolish pastimes for your weekend: On tap for the Fool Radio Show is an interview with Matt Ridley, author of the popular biotechnology book, Genome. Also, in case you missed it, I wrote a Q&A on Cisco Systems for our new Stock Research area. Have a great weekend!

Phil (TMFGrape on the boards)