Just because banks are complicated doesn't mean that analyzing them must be as well. In my opinion, an investor can learn most of what they need to know about a prospective bank in 15 minutes or less by looking at only three numbers. Read on to learn what these three numbers are and how they can reveal whether a bank is worth an investment.
1. Lowest annual return on equity since 2008
Since the era of modern banking began in 1865, more than 17,300 banks have gone belly-up. That averages out to 116 a year.
To avoid banks prone to this fate, investors should focus exclusively on companies with long histories of lean operations and prudent risk-management -- which, as I've discussed elsewhere, aren't independent of one another. These are cultural traits that can endure for decades at a well-run bank, but once lost, they're unlikely to be recovered.
To gauge whether a specific bank has the type of culture that will see it through future crises, investors need only look at how it performed during the last one. And the figure that best captures this is a bank's return on equity -- that is, annualized net income divided by shareholders' equity.
Consequently, the first number investors should look at when analyzing a bank stock is the bank's lowest annual return on equity since 2008. If that figure is negative, long-term investors should avoid the bank altogether.
2. Average efficiency ratio over the past three years
The efficiency ratio measures the percentage of a bank's net revenue that's consumed by its operating expenses. The purpose of this second figure is to gauge whether a bank has what it takes to generate outsized returns.
An efficiency ratio in the low 60% range or below is important not only because it means that more revenue will filter down to a bank's bottom line, but also because efficient banks have less incentive to compromise their underwriting standards by originating overly risky loans in exchange for higher yields.
I've even gone so far as to say that the efficiency ratio is the single most important metric when it comes to identifying a bank stock that's capable of outperforming its peers.
Why an average of the last three years? Because this reduces the residual noise from the financial crisis and thereby gives investors a purer view of a bank's normalized operations. It also reduces the chance that you'll be thrown off by a single-year anomaly.
3. The latest year's revenue divided by assets
Finally, while running a profitable bank is primarily about managing expenses and underwriting good loans, a bank must also earn enough revenue to ensure that, after expenses and other ancillary charges are subtracted, it has a respectable amount of money to distribute to shareholders, buy back stock, or boost book value.
Here's the quick and dirty math that sheds light on how much revenue is enough: Generally speaking, a bank's net income should be equal to at least 10% of its shareholders' equity if it wants to earn its cost of capital. And because a bank's capital is typically leveraged by a factor of 10 to one, that equates to a return on assets of 1% or more.
However, because even good banks typically have efficiency ratios in the high-50% to low-60% range, and because they must provision for future loan losses and income taxes, you generally want to see a bank that generates annual revenue well in excess of 4% of its total assets for the same year -- and preferably in excess of 4.5%.
Who does this leave us with?
If you've made your way through the tables above, you may have noticed a pattern. Namely, while Wells Fargo, U.S. Bancorp, and BB&T outperformed their peers across the board, Bank of America, Citigroup, and Regions Financial, among others, failed to measure up in at least one of these benchmarks. In short, consider buying the former three and avoid the latter group.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup Inc, Fifth Third Bancorp, JPMorgan Chase, PNC Financial Services, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days.