Last month, Forbes released its annual list of the best U.S. banks. The list was comprehensive and presented in an authoritative tone.
The problem is that Forbes' methodology leaves a whole lot to be desired, and as a result, many of the banks on the list are wildly misplaced.
Why these rankings don't stack up
Bank of America (NYSE:BAC) is a bank we're all familiar with, and it serves to highlight my point. B of A comes in at No. 88, six spots behind No. 82, Wells Fargo (NYSE:WFC).
Citigroup (NYSE:C) is the highest-ranked of the megabanks at No. 64, and JPMorgan Chase (NYSE:JPM) rounds out the big four at No. 73. One of my favorites, M&T Bank (NYSE:MTB), is ranked just behind B of A at No. 83.
Now, look at this chart, which includes the KBW Bank Index as a benchmark for the industry. Something doesn't quite add up.
Over the past 10 years, Forbes' top bank of this group, Citigroup, is by far the worst performer. Bank of America has done slightly better but still lousy, yet it's ranked higher than M&T and only six spots behind Wells.
That doesn't pass the sniff test.
Forbes' methodology misses some big points
It's easy to pick a bank here and there and argue that it should be higher or lower, but that's not my aim. Rather, I'm arguing that the methodology omits absolutely vital criteria, skewing the results from the top to the bottom.
The markets, as demonstrated by the stock performance chart, also disagree with Forbes' assessment. What's the problem?
Here's the methodology, quoted from the original article:
The metrics to rank the banks included net interest margin; nonperforming loans (NPLs) as a percentage of loans; nonperforming assets as a percentage of assets; reserves as a percentage of NPLs; two capital ratios (Tier 1 and risk-based) and leverage ratio. The data is based on the regulatory filings of banks and thrifts for the period ending Sept. 30. We also factored in return on average equity over the last 12 months.
While [financial-data company SNL Financial] provided the data, the rankings are done exclusively by Forbes. The final component of the rankings was revenue growth for the latest 12 months based on data from FactSet Research Systems. The nine metrics were weighted equally in the final ranking.
Forbes used two profitability metrics (net interest margin and return on equity), four capitalization metrics (reserves, Tier 1, risk-based, and leverage ratios), and two credit quality metrics (NPLs to loans and NPLs to assets), and then it threw in revenue growth to round out the formula.
Forbes was right to emphasize soundness first -- capitalization and credit quality account for two-thirds of the weightings -- followed by profitability and, lastly, growth. I'm a firm believer in John Medlin's "three legged stool" philosophy of bank management.
In my opinion, though, return on assets is more significant over time than return on equity. I also feel that the efficiency ratio, again reviewed over time, is an absolute must for any bank analysis.These two measures are key to Warren Buffett's evaluation of banks, but they're nowhere to be found here.
More than anything else, what this ranking lacks is an attempt to capture a bank's management and culture. All financial ratios and metrics are reflections of management decisions on how to operate the bank and how to compete in the marketplace. Management and culture are what separate the best from the rest.
The challenge is that this so impossible to quantify. To me, the solution is to consider the bank's historical performance through previous downturns. Past performance is the best proxy investors have to predict future management decisions and evaluate culture.
It's a good start, but the list needs work
I don't want to be overly critical, as ranking the nation's banks is an exceptionally difficult thing to do, and this methodology is a good start. My point is that it is just that -- a start. There is more work to be done.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo and owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.