One key metric for evaluating bank stocks is the efficiency ratio, which measures a bank's total expenses expressed as a percentage of its total revenue. For example, if a bank has a 60% efficiency ratio, it means that for every $0.60 the bank spends, it generates $1 of revenue. This ultimately means that strong banks have lower efficiency ratios, because they are spending less to generate more revenue.
The efficiency ratio is important when it comes to Wells Fargo (WFC -2.37%) as the bank continues to execute its turnaround. I think Wells Fargo can still improve its efficiency ratio, which will translate into better profitability and returns moving forward. Here's why.
Past efficiency performance
If you take a look at Wells Fargo's efficiency ratio over the past five years, you can see how the number has deteriorated and improved. Large banks like Wells Fargo typically seek to have an efficiency ratio under 60%.
|Year||Wells Fargo Efficiency Ratio|
Wells Fargo has not had a good efficiency ratio for quite some time. The main culprit is the bank's phony-accounts scandal, in which employees opened millions of deposit and credit card accounts without the consent of customers. The scandal came to light in 2016, and since then, the bank has gotten pummeled by regulatory fines and consent orders. This has forced the bank to spend more on regulatory controls to prevent another scandal like this.
Furthermore, the Federal Reserve at the beginning of 2018 placed an asset cap on the bank, which prevented Wells Fargo from growing its balance sheet and in turn has hurt revenue over the years. So expenses, the numerator in the efficiency ratio, have risen, while revenue, the denominator in the equation, has been stagnant or on the decline, putting pressure on the efficiency ratio and overall profitability.
Falling below its peer group
As you might expect, Wells Fargo's efficiency ratio has risen higher than that of its peers, such as JPMorgan Chase, Bank of America, and Citigroup.
|Bank of America||60.2%||64.6%||67%|
For the most part, having a lower efficiency ratio consistently can be a good indicator of a bank's stock price and valuation performance. As you might expect, JPMorgan trades at the highest valuation of this peer group.
But a lot has happened over the past two years. The COVID-19 pandemic has impacted all banks' efficiency ratios, so you can't view these exactly in a straight line. While Citigroup has historically had a better efficiency ratio, the bank has come under regulatory pressure and has been dealing with higher expenses as a result. Meanwhile, Bank of America and Wells Fargo have been getting their acts together, which can be seen if we look at how the efficiency ratio has trended at these three banks in recent quarters.
|Bank||Q1 2021||Q2 2021||Q3 2021||Q4 2021|
|Bank of America||68%||70%||63.4%||66.8%|
Bank of America's efficiency ratio has bounced around a bit, but the bank also guided to hold expenses flat in 2022, which would be a huge accomplishment given how high inflation is. Wells Fargo's stock has performed extremely well over the past year because investors see the bank executing on a plan to greatly improve its efficiency ratio and eventually get it into the 50s. Wells Fargo CEO Charlie Scharf at the beginning of 2021 embarked on an ambitious plan to take out $8 billion of gross expenses over a three-to-four-year period. The bank has been making progress on this plan, and recently Scharf said the bank would raise its target to $10 billion of gross cost savings.
Follow the efficiency ratio at Wells Fargo
It's not a good idea to buy or sell a stock based on one metric, but the efficiency ratio provides a good overview of how expenses and revenue are trending. One reason I know that Wells Fargo can perform better than it has in terms of profitability is that I see a clear path for management to reduce expenses, as well as a clear path for revenue growth with higher interest rates and eventual removal of the asset cap.