It's safe to say that the great majority of investors are familiar with, and commonly use, financial ratios such as price/earnings, return on assets, and debt to equity, among others. These are valuable tools that help us understand how a particular asset is performing.
The universe of ratios expands greatly in the banking sector, since any lender's results are stuffed with financial figures that can be mashed together in a million ways.
With that in mind, three of our contributors pick what they believe to be an extremely useful, yet unheralded, metric that can help determine whether a bank is worthy of an investor's consideration.
Matt Frankel: One metric that all bank investors should be familiar with is the efficiency ratio. Basically, this number tells you how good a bank is at using its assets to generate revenue.
The basic formula for calculating the efficiency ratio is the bank's expenses dividend by its revenue. So, if a bank spent $5 billion and had revenues of $10 billion, its efficiency ratio would be 50%. The lower the efficiency ratio, the more efficient the bank is.
Now, efficiency ratios aren't always an apples-to-apples comparison. For example, banks that operate primarily on the Internet obviously have lower fixed expenses than banks that have to pay for branches, so it's no wonder that BofI Holding, (the "BofI" stands for Bank of Internet) has an efficiency ratio of about 41%, among the best in the business.
However, it can be a good way to compare banks of similar structure, and definitely helps to explain why some banks are valued more highly than others. For example, U.S. Bank and Wells Fargo have efficiency ratios of 53.7% and 56.2%, respectively, and trade at relatively high valuations relative to say, Regions Bank, whose efficiency ratio is 66.4%.
Eric Volkman: A critical ratio I rarely see in standard bank earnings coverage is the net charge-off rate. And that's a shame, because this little number can tell us a lot.
Not every loan will be paid back, of course. Based on estimates and certain conventions, a bank will calculate how much of its loan book is unlikely to be collected -- the gross-charge-off. This amount is reduced by the loans included in that amount which are actually paid over the course of a certain time period.
That's the net charge-off amount, which is then divided by the average level of loans outstanding over the relevant period. This yields the net charge-off rate.
At the risk of stating the obvious, the lower the net charge-off rate, the better.
The beauty of the net charge-off rate is that it shows, at a glance, that most critical aspect of a bank's lending efforts -- the quality of its underwriting.
Dan Caplinger: One of the most important ways to evaluate a bank is whether it has adequate capital to ride out down phases of the business cycle, and one favored measure of bank health is the Tier 1 Capital Ratio. The gist of this measure is to include core capital and reserves available to the bank in times of financial distress. The ratio takes Tier 1 capital and compares it to its asset base, which is typically adjusted to measure risk levels of various loans.
New requirements under the Basel III accords have led the FDIC to further divide Tier 1 Capital into Common Equity Tier 1 and Additional Tier 1 capital. Common Equity Tier 1 capital includes common shareholders' equity, retained earnings, accumulated other comprehensive income, and qualifying minority interests. It requires deductions for goodwill, deferred tax assets, and other intangible assets, and typically includes adjustments for unrealized gains and losses tied to hedge positions. Additional Tier 1 capital includes perpetual preferred stock, minority interests that don't qualify for Common Equity Tier 1 treatment, and capital raised from government programs like TARP if it initially qualified as Tier 1 capital. Banks then have to deduct certain investments in other financial institutions to come up with a final figure.
As complex as the calculation is, comparing Tier 1 Capital Ratios across the industry can give you a sense of relative health of various banks. It's not the only measure of bank strength, but it's a key figure that regulators will watch closely, and so you should too.
Dan Caplinger has no position in any stocks mentioned. Eric Volkman has no position in any stocks mentioned. Matthew Frankel owns shares of Regions Financial. The Motley Fool recommends BofI Holding and Wells Fargo. The Motley Fool owns shares of BofI Holding and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.