Investing in banks can get really complicated, really quickly.
Bank accounting is a nightmare of unique calculations far outside the scope of that Accounting 101 course you took in college. The regulations that govern nearly every aspect of the business are constantly evolving, and constantly muddying expectations for returns and profitability. Even calculating a bank's bottom-line profit is an exercise in extreme confusion.
Fortunately, there's a shortcut. And it happens to be the same shortcut Warren Buffett uses to quickly evaluate a bank's potential for investment.
The one number to rule them all
That shortcut is a bank's return on assets (ROA). Will this number give you all of the information you need to know before you invest? No. But it will point you in the right direction. It's a shortcut after all, not a crystal ball.
The logic behind looking to return on assets is pretty simple. First, it strips out a bank's leverage position. If we were to use return on equity, a bank could simply be taking on excess leverage to build up its balance sheet and boost earnings. The financial crisis is evidence enough of why taking out huge amounts of debt to boost earnings isn't the best long-term strategy. Return on equity is important, but it can also be misleading.
Second, return on assets takes into account the efficiency of the assets on the books. To achieve above-industry ROA, a bank must have its expenses under control in order to yield a higher level of profit per dollar of asset. An efficient bank is a good bank.
There is a risk that a bank with poor expense control could boost its earnings by taking on riskier and higher yielding assets. That should be considered -- after all, banks are unique in that after they sell their product, they must get it back (i.e., loans must be repaid). This is a real concern, but remember that looking to return on assets isn't the be-all or end-all of bank stock analysis. It is a great starting point, though.
Let's let Buffett weigh in on the matter
The above is my take on return on assets. The Oracle of Omaha presents a slightly different angle related to valuation. In an interview with CNBC on March 4, 2013, Buffett explained his logic thus:
Yes, well a bank that, a bank that earns 1.3 or 1.4 percent on assets, is going to end up selling above tangible book value. If it's earning six-tenths of a percent, or five-tenths of a percent on assets, it's not going to sell below. Book value is not key to evaluating banks. Earnings are key to evaluating banks, and you earn on assets.
Now, it translates to book value, because it -- to some extent, because you're required to hold a certain amount of tangible equity, compared to the assets you have. But you've got banks like Wells Fargo and USB, that earn very high returns on assets, and they sell at a good price to tangible book.
For him, it's all about the kind of prices a long-term, value oriented investor should be willing to pay. It makes a ton of sense when you take a step back: The best banks will command a premium, and that's OK because they are the best!
So, which banks are the top dogs as of the third quarter?
With third-quarter results now tallied, we can do a quick screen of the largest regional and national banks to find the best of the best.
Does this mean these five institutions' stock prices will go up in the next year? Nope.
Does it mean these five stocks are going to be winning long-term investments? Not necessarily.
What it does mean is that SVB Financial Group (NASDAQ:SIVB) is able to generate a whole lot of profit for every dollar of assets on its balance sheet. It means Wells Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB) have their expenses well under control. It means Capital One Financial Corp (NYSE:COF) and Prosperity Bancshares (NYSE:PB) both turned in great third-quarter results.
It means these five stocks are a great list to use to start your search for that winning long-term investment.