In this edition of Industry Focus, host Michael Douglass and Fool contributor Matt Frankel discuss bank metrics. The traditional valuation metric, the price-to-earnings ratio, may not be the best metric to use when evaluating bank stocks. In this video, Michael and Matt discuss some of the key metrics you can use to assess the health of banks and compare their stock valuations with peers.
A full transcript follows the video.
This video was recorded on Oct. 23, 2017.
Michael Douglass: So before we hop into bank metrics, I just want to point out, this is going to be a very high-level look at them. If you really want to understand how to invest in banks, we have a great article that breaks down how to understand a bank piece by piece. When I took over our financial coverage in 2014, it was my Bible, and really still is today. Send us an email at email@example.com, and I will be happy to share it with you. Again, that's firstname.lastname@example.org.
Let's talk about investing in big banks. I think the first thing we should talk about is, at their core, banks taking money as deposits and then lending that money out as loans. So you want to know, frankly, whether they're good at lending that money to people who aren't going to default on the loan, which would impact their profitability very negatively. One of the ways you can measure that is with the net charge-off-to-loan ratio, which is what percentage of loans are so delinquent and so unrecoverable that the bank thinks it won't get its money back. So lower is, of course, better. Other thoughts on that, Matt?
Matt Frankel: To follow up on what you just said, this is why Citigroup (C -1.52%) and Bank of America crashed after the financial crisis, while U.S. Bancorp never even had a quarter where they were in the red. Their defaults, they ticked up, but it was never to the point where they were losing money. This is what you were talking about with, they're much better at figuring out who they should lend money to.
Douglass: And actually, you've made a point that I want to draw out a little bit more, which is, when the economy tanks, those numbers are going to increase. There are going to be more people who become delinquent, whether you're a great lender or a really bad lender. But one of the things to keep in mind is, look at each lender in comparison to the others. If you have one that has a much lower net charge-off-to-loan ratio versus another, that's a good sign for that company. And that's just something to keep in mind. The absolute numbers matter, but a rising or sinking tide will affect all the boats. So you want to keep that in mind and compare them to each other.
Let's talk about expense management a little bit.
Frankel: Sure. This is where a metric called the efficiency ratio comes into play. It's actually really easy to calculate. Take the bank's non-interest expense and divide by the total revenue it generates. It's basically how much a bank is paying in order to generate its revenue. Lower is better. Generally, 60% or so is what you're looking for for a big bank. About half of the banks we talked about are lower than that; about half of them are higher than that. But that's kind of the benchmark for a big bank.
Douglass: Right. And U.S. Bancorp, to give it a shout out, has the lowest efficiency ratio of that bunch at 54.3%.
Frankel: JPMorgan is actually in a close second, and surprisingly, Citigroup is up there, too.
Douglass: Right, it's interesting. Again, this is not what you would historically expect, given the history of the banking industry. But it's a new day, and new things are happening.
Let's talk about bank profitability as well. That's return on assets and return on equity. Looking at both of those, that's how you can understand how well the bank takes that hopefully low credit risk and makes money off it.
Frankel: The two benchmarks you want to look at are 1% return on assets and a 10% return on equity. Return on assets is a measure of how well a bank takes all of the money it has and uses that to make more money. Return on equity is how well it's using the money shareholders have invested to turn a profit.
Douglass: Exactly. And let's also talk a little bit about what happens if everything bad hits the fan. There are a ton of different ratios that you can use to try to stress-test a bank a little bit. Of course, the banks actually go through stress tests with the Federal Reserve. But one that's pretty commonly used is the tier 1 common capital ratio. It's reported on by every big bank, and it basically measures how much strain they can take before really bad things start happening. So the higher the ratio, the better.
Frankel: Right. At this time, all of the banks are well above the regulatory threshold. I think most of them are probably double the regulatory threshold at this point. This just kind of tells you, under a worst-case scenario, which, I think the stress-test worst-case scenario is something that's even worse than the financial crisis was, something like 10% unemployment, things like that, and how well a bank would hold up before it would start losing money or need a bailout like they did during the financial crisis. Again, this is another metric you compare with other banks and take with a grain of salt at this point, because everything is going well.
Banks have really recapitalized because regulations are high. This is another thing to keep an eye on, if regulations get rolled back. Right now, it's actually looking pretty good across the board. I think the highest capital ratio is Morgan Stanley at this point, and Goldman Sachs. Both investment banks have really high capital. Among the other banks, Citigroup surprisingly is the top, with a 30% tier 1 capital ratio.
Douglass: Right. And of course, when thinking about each of these metrics, the next question is, of course, OK, cool, that's what you're getting, but what are you paying for that? And there are a lot of different valuation metrics out there. The one that I prefer for banks is price to tangible book value. Book value is essentially what the business' assets are worth. That includes intangible assets and goodwill, which, frankly, those are hard to value. So I tend to prefer tangible book value because it's, well, tangible assets, so it's easier to get a precise valuation for, and then price over that basically gives you a sense as to what that valuation looks like -- again, in comparison to other banks.
Frankel: And this is a good one to use in conjunction with the return on assets, return on equity, and efficiency ratio we were talking about. You want to know how much you're paying for a bank, given its profitability. For example, U.S. Bank trades at by far, by far, by far the highest price-to-tangible book value. Just to kind of give you a reference without telling you too much, going too much into the numbers, they're about 3 times tangible book value right now. For comparison, JPMorgan is a distant second at 1.8 times book value. The industry average is between 1.3 and 1.5 times book value. So U.S. Bank is by far the most profitable of the big banks, but you pay for it.
Douglass: Right. So that's one of the things you have to weigh when you're engaging in an investment thesis about these companies.