It's no wonder Warren Buffett loves bank stocks.

The legendary billionaire investor has more than 30% of his $170 billion portfolio at Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) dedicated to this one industry.

The reason why is simple: Bank stocks possess many of the important Buffett must-haves to be considered for his portfolio. First, banking institutions serve an important societal need that will never go away. Second, banking business models are relatively simple to understand, a key requirement of Buffett's investing philosophy. Third, despite the health of many banks improving dramatically since the 2008 financial crisis, some bank stocks are still trading at a bargain -- a key indicator that now is the best time to invest.

Let's examine the basics of bank stock investing, the history of bank stocks, and how to know when you've found one worth investing in.

The exterior of a building with the words "Bank" written on it.

Image source: Getty Images.

How banks make money

Banks make money by lending money at a higher rate than what they pay to depositors. Banks collect interest (the money a borrower pays for the ability to use the bank's money) on loans and pay interest (the money a bank pays depositors for allowing their money to be held). The difference between these two rates is known as net interest margin (or 'the spread') and is how traditional banks make money.

But how exactly are interest rates set? One key force is the Federal Reserve, the central bank of the United States which sets the rate banks lend to one another, known as the London Interbank Offered Rate, or LIBOR.  Using the LIBOR as a benchmark, banks then adjust consumer loan rates up or down. Generally, when the Federal Reserve raises interest rates, the rates that banks charge on loans grows faster than the rate paid out on deposits. As a result, a rising interest rate environment makes it easier for banks to profit.

Most traditional banks now also make money from non-interest income, a way to diversify their revenue stream even when interest rates are low. These include charges such as transaction fees, overdraft charges, mortgage fees, trading fees and a laundry list of other sources which can make up a significant amount of revenue for some banks.

Understanding how a bank makes money helps predict how market events, like downturns in the credit cycle or interest rate hikes, will likely impact one bank over another.

History of bank stocks

In the 200-year plus timespan of the financial industry, the United States has experienced nearly 14 major bank panics, or about one every 16 years. Since 1934, over 3,500 banks have failed and, on average, eight banks are forced to shut their doors each year.

The Great Depression
The most notable financial disaster was the Great Depression of 1934. The stock market crash of 1929 led to widespread panic, causing investors to sell 12.9 million shares in one day, more than triple the average daily volume. Fears about the economy led consumers to withdraw money from financial institutions in droves, causing banks to fail. Rising interest rates were insufficient to coax depositors back to banks. Rather, they traded in their dollars for gold which created a dwindling supply of money the Federal Reserve couldn't replenish. This greatly devalued the dollar. Gross domestic product was slashed in half from $103 billion to $55 billion. Unemployment rose to nearly 25%  forcing many Americans into poverty. Undoubtedly, this was the worst economic disaster in American history.

S&L crisis of 1980s
Though the 2008 credit crisis is fresh on the minds of most investors, another banking crisis during the 1980s was equally as crippling. 

No single reason led to the explosive surge in bank failures in the 1980s. The banking crisis of 1980s, or Savings & Loan (S&L) crisis, was a perfect storm of several forces: rising interest rates drove depositors to withdraw money from small S&Ls and invest in higher-yielding money market accounts. In order to offset losses from fleeing depositors, the federal government loosened regulatory restrictions of banks, ultimately allowing S&Ls to fund high-risk, speculative loans in real estate and junk bonds. 

The end result was massive insolvency. Over 700 of S&Ls and commercial banks with assets over $407 billion were closed by the end of the 1980s. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) was passed, and brought with it, among other things, oversight of the Federal Depositors and Insurance Corporation (FDIC) designed to prevent future financial disasters. And by all accounts, the increased regulations were successful. Well, at least until 2008.

Financial crisis of 2008
Similar to the S&L crisis, the financial crisis of 2008 was a perfect storm of deregulation, rising interest rates, and high-risk speculation by banks. In order to compete with foreign banks, U.S. banks lobbied for the ability to invest deposits in derivatives. Banks got their wish when the Gramm-Leach-Bliley Act of 1999 repealed the Glass-Stegall Act of 1933. This latter regulation protected depositor funds from being used for risky investments while the former regulation opened the doors wide for banks to invest in subprime and toxic loans. This led to nearly $22 trillion in losses and years of recovery.

The Dodd-Frank Act, signed into law in 2010, was in direct response to the 2008 financial crisis. One of the key provisions is known as the Volker Rule (Title VI of the Act) restricts the ways banks can invest deposits, limits speculative trading, and regulates derivatives, like credit default swaps. Additionally, banks with more than $50 billion in assets are now required to undergo regular stress tests to see just how a bank would survive hypothetical economic crises.

What are the different types of bank stocks?

Generally, there are three different types of banks: commercial banks, investment banks, and universal banks.

Commercial banks are what most people think of when they hear the word "bank." Their bread-and-butter is built around a bank's core business: take in deposits from customers, make loans to other customers, and profit from the difference between them. Banks like Wells Fargo and U.S. Bancorp make up this class of commercial banks.

>In contrast to commercial banks, investment banks, like Morgan Stanley and Goldman Sachs, focus their core business on providing financial services to other corporations, companies, and governments. In addition, they also provide services such as facilitating complex financial transactions, providing advisory services, stock trading operations, and asset management. When a company announces an initial public offering (IPO), when it starts selling stock to public markets, these banks are the ones behind the transactions.

The largest banks in the U.S. are the universal banks and include companies like Bank of America, Citigroup, and JPMorgan Chase. These banks offer the traditional deposit and loan offerings along with investment banking, wealth management, and advisory services. They offer the advantage of a diversified revenue stream across multiple business segments and an international scale.

Largest U.S. Bank stocks by market cap

U.S. Bank

Market Capitalization (millions)

JPMorgan Chase

$376,168

Bank of America

$304,675

Wells Fargo

$248,031

Citigroup

$181,808

Goldman Sachs

$97,001

Morgan Stanley

$94,932

US Bancorp

$84,109

Capital One Financial

$46,861

Data by S&P Capital IQ as of April 15, 2018.

Top 3 bank stocks by market cap

Bank of America
Founded in 1874 and based in Charlotte, NC, Bank of America is one of the country's largest banks with over $2.2 trillion in assets, 4,500 financial centers, and over 16,000 ATMs. Bank of America also provides credit cards, asset management, and other money-related services.

With 144 years of history, Bank of America is no stranger to economic crises. The 2008 financial crisis left the company bruised and battered after two notable acquisitions, and that brought years of costly litigation and substantial losses. Fast forward to 2018, with a new CEO and a more conservative strategy, Bank of America is on par to become one of the best turnaround stories in the banking industry.

JPMorgan Chase
The largest U.S. bank, JPMorgan Chase, was founded in 1799 and headquartered in New York, NY. With assets over $2.6 trillion, JPM's core business is focused on community banking, investment banking, and wealth management.

In comparison to its peers, JPMorgan managed to emerge from the 2008 financial crisis in better shape than its peers. Under the helm of CEO Jamie Dimon, JPM was the only bank to remain profitable throughout the 2008 downturn. Sensing the growing default risk, the company largely stayed away from the toxic sub-prime and derivative markets, a move that brought criticism for being too conservative. Even though JPM didn't escape completely unscathed, it stayed sufficiently healthy to rescue Bear Stearns and Washington Mutual from collapse at the government's request. JPM continues to lead the big bank pack, recently overtaking Bank of America to become the largest bank by assets in 2017.

Wells Fargo
Wells Fargo
, headquartered in San Francisco, CA, operates its business in three divisions -- community banking, wholesale banking, and wealth and investment management. Founded in 1852 during the gold rush, WFC is a community-based financial services company with more than $1.9 trillion in assets.

Wells Fargo was remarkably stable throughout the Great Recession of 2008 with a conservative approach to loan and deposit growth and avoiding risky investments. However, in 2017, the fallout from the fake accounts scandal damaged the bank's reputation as a trustworthy neighborhood bank and led to the ouster of its CEO. Only time will tell if Wells Fargo is a turnaround story in the making and if it can regain its status as a premier commercial bank.

How to calculate profitability ratios for a bank

Since many banks generate profits primarily from lending activities, it's important to know which financial metrics paint the best picture of how profitable a bank really is.

Here are 4 key profitability metrics to analyze traditional bank stocks:
1. Return on Equity (ROE)
2. Return on Assets (ROA)
3. Net Interest Margin (NIM)
4. Efficiency Ratio

Profitability Metric

How to calculate

Ideal Benchmark

Return on Equity (ROE)

Net Income/Total Shareholder's Equity x 100

At least 10%

Return on Assets (ROA)

Net Income / Total Assets x 100

At least 1%

Net Interest Margin (NIM)

Net Interest / Total Interest Generating Assets x 100

At least 3%

Efficiency Ratio

Noninterest Expense/Net Revenue x 100

60% or lower

Chart by Author.

Return on equity
(ROE) is how much profit a company generates as a percentage of shareholders' equity or the amount that would be returned to shareholders if all assets were sold and debts repaid. The higher the ROE, the more efficiently a company is putting shareholder's equity to work.

Calculating ROE simply requires dividing net income by total shareholder's equity and multiplying by 100.

ROE = Net Income/Total Shareholder's Equity x 100

Using Bank of America as an example, the trailing five-quarter average for shareholders' equity was $269.1 billion, and net income was $2.3 billion. Dividing the two figures equates to a healthy ROE of 11%.

Generally, a ROE of at least 10% is considered pretty good. Comparing Bank of America's ROE to the industry average of 8.4% suggests Bank of America is generating profit more efficiently than its peers.

Return on assets
Another profitability measure is return on assets (ROA). ROA is a percentage of the overall profit, or net income, a company makes relative to its total assets (which includes interest-earning loans, securities, cash, etc).

Return on Assets = Net Income / Total Assets x 100

In 2017, Bank of America generated net income of $18.2 billion with average total assets of $2.3 trillion (an average of total assets from the previous five quarters). Dividing those two figures and multiplying by 100 equates to a ROA of .89%.

A good benchmark for bank stocks is ROA of at least 1%. While this may seem low relative to other industries -- like software stocks which can average upwards of 13% ROA -- it's important to examine ROA in relation to other bank stocks, which had an average ROA of .95% at the end of 2017. 

So how would one interpret a bank with an above average ROE but a slightly below-average ROA? A high ROE signals that management is effectively generating returns from shareholder investments specifically. But ROA measures how well the banks uses all of its financial resources -- both debt and equity -- to generate profits. A slightly below-average ROA hints management may not be using its resources as effectively as a high ROE might indicate. So be sure to examine both ROA and ROE together.

Net interest margin
A key measure of a bank's profitability is net interest margin (NIM). Simply put, net interest margin is the difference between the interest a bank receives and the interest a bank pays in relation to its total interest-generating assets.

Net Interest Margin = (Interest Income from Loans – Interest Expense to Depositors) / Total Interest Generating Assets x 100

Going back to the Bank of America example, net interest income (NII) was $45.8 billion at the end of 2017 and average interest-generating assets totaled $1.9 billion. This equates to a NIM of 2.5%, slightly below the ideal margin of at least 3%.

NIM tends to move in tandem with interest rates. As interest rates rise, so do bank interest margins. At the end of 2017, the industry average NIM was 3.17%, but this figure went as high as 4.91% in 1994, the same year the Federal Reserve started raising rates after the savings and loan crisis of the 1980s.

Generally, a NIM of at least 3% -- and one that is steadily increasing -- is a good sign that a company is profitably managing its assets. 

Banks can improve NIM by increasing the number of borrowers who are willing to pay higher interest rates (loan growth) or increasing the number of depositors willing to accept lower interest rates (deposit growth). For investors, a positive and improving net interest margin is a good sign. But buyer beware -- rapidly fluctuating or steep increases in NIM could be a sign that a bank may be chasing profits at the expense of quality.

Efficiency ratio
When evaluating a bank's profitability, it's important to view it in the context of how efficient a bank is at generating its revenue. A metric called efficiency ratio does just that. It's calculated by taking the bank's operating costs, known as a non-interest expense, and dividing it by the net revenue it generates.

Efficiency Ratio = Noninterest Expense / Net Revenue x 100

First, add Bank of America's 2017 net interest income of $44.7 billion to its noninterest income of $42.7 billion, which equates to $87.4 billion in net revenue. The noninterest expense of $54.7 billionis then divided by total revenue which equates to an efficiency ratio of 63%. This means that $0.63 was spent for every dollar in revenue Bank of America generated in 2017.

The best-run banks tend to keep efficiency below 60% as a lower efficiency ratio indicates a bank is skillfully able to turn resources into revenues. Additionally, more efficient banks tend to have fewer loan defaults. 

How to assess a bank's risk

A bank is only as a good as the quality of its loans. The riskier the loan portfolio, the greater the risk of loan defaults which jeopardizes long-term profits for a bank.

Here are 3 key bank risk metrics to use when analyzing bank stocks:
1. Non-performing loan (NPL) ratio
2. Coverage of bad loans
3. Net charge-offs (NCO)

Quality Metric

How to calculate

Ideal Benchmark

Non-performing loan (NPL) ratio

Total Non-Performing Loans/Total Outstanding Loans x 100

Below 2%

Coverage of bad loans

Allowance for loan loss provision/Total Non-performing loans x 100

At least 100%

Net charge-offs (NCO)

Net Charge-off Rate = Total Net Charge-Offs/Total Loans x 100

Lower the better. Compare to peers.

Chart by Author.

Non-performing loan ratio
For obvious reasons, a growing percentage of non-performing loans (NPL), or loans that are at least 90 days past due and approaching default, is never a sign of a healthy loan portfolio.

Calculating the NPL ratio is relatively simple. Simply divide total non-performing loans by the total amount of outstanding loans in the bank's portfolio.

NPL ratio = Total Non-Performing Loans/Total Outstanding Loans x 100

At the end of 2017, Bank of America reported $6.8 billion in non-performing loans and total outstanding loans of $936.7 billion for a NPL ratio of .8%, below the industry average NPL ratio of 1.2%. These are all good signs that suggest BAC's loan portfolio is healthy and well-managed. For perspective, during the 2008-2009 financial crisis, loans approaching default peaked at an astounding 5.6% of all loans. 

Ideally, the lower the percentage of bad loans, the better. A NPL ratio above 2% should give an investor cause for concern.

Coverage of bad loans
Not every loan a bank lends out will get repaid. Banks make an allowance on their balance sheets for these defaults, called coverage of bad loans or loan loss provision.

Coverage of bad loans = Allowance for loan loss provision/Total Non-performing loans

The allowance Bank of America set aside for bad loans was $11.2 billion in 2017, and total non-performing loans were $6.8 billion. This equates to a respectable 165% bad loan coverage. Ideally, the buffer established to account for inevitable loan defaults should be at least 100% to ensure the bank is adequately prepared for economic downturns. The more coverage, the better.

Net charge-offs
A charge-off is a declaration by the bank that money lent out is unlikely to be collected. Generally, this is a delinquent debt that has gone over 6 months without payment. The net charge-off rate, which is net charge-offs divided by total loans, represents the percentage of total loans unlikely to be paid back. 

Net Charge-off Rate = Total Net Charge-Offs/Total Loans x 100

With $3.9 billion in net charge-offs and total loans of $918.7 billion, the net charge-off rate for Bank of America was .42%, below the industry average of .52% at the end of 2017.

Obviously, the lower the net charge-off rate, the better. But it's important to view this number in the context of the current credit cycle – the number of loans that don't get paid back tends to increase when the economy is struggling, so you want to view net charge-off rates across banks to see where a bank falls in relation to its peers.

Valuing a bank stock

Price-to-earnings ratio is a helpful metric for understanding how cheap or expensive a stock is relative to its earnings. But for bank stocks, a better metric to use is price-to-tangible book value (P/TBV).

P/TBV measures how much a bank is trading at relative to its actual assets. This is in contrast to the price-to-book(P/B) ratio which takes into account intangible assets, or assets that lack physical substance such as patents, brand names, and goodwill. The P/TBV metric strips away those assets to just those that could be reasonably sold if the company were to shut its doors and sell its assets.

Banks generally trade between half book value and two times book value. As a general rule, banks trading above 2.0 times book value may have limited upside potential and high downside risk.

Assessing whether or not you'd be willing to pay more for one bank over another comes down to whether you believe the bank has good earnings, good growth opportunities, and is less risky in its pursuit to grow relative to its peers. Keep in mind though, you ultimately get what you pay for. Some banks are cheap because they attempt to grow their loan portfolios at the expense of quality, which means default-risk increases and jeopardizes future profits. Others are cheap because of questionable management practices. Do your homework and consider whether a cheap bank stock is really worth a long-term investment.

Key trend to watch: The rise of fintech

Banks aren't known as beacons of innovation. Their slow processes, high fees, and sometimes questionable lending practices have created an industry ripe for disruption. Fintech, short for financial technologies, could be the disruptor to do just that.

Fintech includes a broad array of applications, many of which banks have already started adopting like chip-enabled card systems and mobile banking apps. But the real pressure comes from newer, more innovative approaches to how consumers banks: peer-to-peer (P2P) lending and payments, robo-advisors, and brokers offering cheap stock trades.

Innovative style start-ups are spinning up and exploiting many of these areas such as The Lending Club, Square, and Robinhood to name a few.

It's difficult for banks to adapt old systems to these new, more agile tech players, but this doesn't mean banks are sitting idly by. For example, Bank of America and other large banks recently began integrating peer-to-peer mobile provider, Zelle, into their online banking platform, allowing customers to send payments to friends and family directly via the BAC mobile app. P2P payments through Zelle shot up 84% to nearly 68 million for the Charlotte-based bank in 2017.

Whether or not fintech will completely overhaul the banking business model is up for debate. What we do know is that fintech firms are forcing banks to either step up their game or risk becoming obsolete.

Dividends

Bank stocks make great investments for income-seeking dividend investors. Although many banks slashed their dividends to near zero following the financial crisis of 2008, dividends are steadily increasing as the economy has improved. Currently, the average dividend yield for the financial services sector is 1.87%   compared to 1.89% for the S&P 500.  

But one key industry catalyst could send dividends higher. That's the 2017 Tax Reform Act which dropped the corporate tax rate to 21% from 35%. Some Bank CEOs have suggested returning the additional capital to shareholders -- albeit cautiously -- likely in the form of dividends. Some analysts estimate average bank dividend increases of 38% in 2018 and 26% in 2019, a sizable boost for income-seeking investors.

Is now a good time to buy bank stocks?

Bank stocks were some of the best-performing stocks of 2017. While the price of bank stocks is nowhere near the bargain basement pricing Buffett picked these stocks up at, there's still plenty of upside for long-term investors.

Banks are now leaner, more efficient, and better equipped to manage the default risk that comes with large loan portfolios. With the potential for a more favorable regulatory and interest rate environment ahead, now could be the best time to invest in bank stocks.

The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.