Return on assets is a fundamental metric that you must understand in order to assess a bank's health, but it doesn't stand alone. Looking at leverage, ROA, and the assets themselves helps give a more complete picture of what's going on with a bank.
In this segment of Industry Focus: Financials, Joe Magyer, the chief investment officer of Lakehouse Capital, joins Gaby Lapera to talk about banking metrics. He reminds listeners not to miss the forest for the trees when evaluating banks. One of the metrics that people frequently gloss over is leverage. Watch to learn about leverage, why it's important, and how to interpret it.
A full transcript follows the video.
This podcast was recorded on Sept. 15, 2016.
Gaby Lapera: I feel like we've covered leverage pretty well. Do you want to talk a little bit about return on assets?
Joe Magyer: Yeah. Leverage can mask bad operations. Return on assets is how much you're going down in profit against your actual assets. That's more of a pound-for-pound version of how your back is doing. Historically, you'll see banks do something between 1%-1.5%. Before the GFC, you saw some banks, particularly Irish banks, had numbers that were just mind-blowing. I want to say they were above 2%, just from memory. I remember looking at them and thinking -- without accusing that anything was wrong, it just seemed unnatural. It was extremely unnatural, that turned out to be the case. What you usually see is, a strong bank will have cross-cycle returns. So, say, over a period of 10 years, an average return on assets of maybe 1.5. A bad bank will be south of one. Banks that are south of one will typically sell at lower multiples than the ones that are higher, because they're not as good of a business. Wells Fargo has historically been on the higher end of that. Citigroup has historically been on the lower end of that.
Lapera: One thing that our listeners might not realize because it's not the most intuitive thing is that a bank's assets are its loans out to people. It's a confusing thing, because for most people, a loan is not an asset. But it is for banks. Which is why, when you take leverage and assets all together, it gives you a more complete picture of a bank than just looking at return on equity would.
Magyer: And there are other things you can do if you want to double-click a little bit and here. You can look at the makeup of, digging into the assets, what kind of loans are made. If they're business loans, that's going to be higher risk, traditionally, than residential mortgages.
Lapera: And even with residential mortgages, there's a bunch of different types. New York Community Bank specializes in multifamily residences, which is apartment buildings, basically, in New York City, which is a very safe real estate market, versus maybe someone who is selling single-family homes near an oil field in Texas.
Magyer: That's a great point. To flash an Australian example, the requirements have changed recently, but up until recently, a bank could make a loan on a residential mortgage. Historically, properties have done very well as an investment class in Australia. The bank would only hold as little as 3% of capital against that loan. So, they would be levered 33:1 on that mortgage. The logic is the same that U.S. banks had before they got their face crushed, which was, "Well, people always pay their mortgages, and there's collateral in the assets, so we're backed up there. There's mortgage insurance, so you don't have to worry about that. And just because one person's mortgage goes south, someone across the country, that doesn't mean that could happen to them." I think we all learned that that's not necessarily the case. Australian banks have not learned that lesson. They will, eventually. I don't know when.
Gaby Lapera has no position in any stocks mentioned. Joe Magyer has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short October 2016 $50 calls on 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.