Senior banking specialist John Maxfield distills his wealth of knowledge about banks and how they work into a simple three-step process that any investor can use to get a handle on whether a particular bank stock is a good investment.

The first step shows how a bank is likely to fare in the next economic downturn, and how to avoid the pitfall of banks that look great when the economy is great, but fail quickly when times get tough. The second step looks at a bank's discipline, and the one thing investors need to know about efficiency ratios. Finally, there are several ways to look at topline revenue to learn about profitability; Maxfield shares his favorite in step three.

Once you've found a bank that passes your tests, how do you know you're not paying too much? Tune to find out!

A full transcript follows the video.

Kristine Harjes: 15 minutes could save you more than just money on car insurance! This is Industry Focus.

[INTRO]

Welcome to the financials edition of Industry Focus. I'm Kristine Harjes, and today we're going to find out from the Fool's senior banking expert, John Maxfield, how to dig into a bank stock the easy way, in 15 minutes or less.

John has spent countless hours analyzing banks, and from this wealth of experience he's been able to distill bank analysis down to just three key metrics that you can use to find out if a bank you're looking at is a good investment.

If you're thinking that this is too good to be true, consider the industry that we're talking about here. All banks really do, at their core, is borrow money at one interest rate and lend it out at a higher one, and they pocket the spread.

Because banks share such similar business models, the beauty of the industry is that once you can analyze one bank stock you're pretty much set to analyze them all and make meaningful comparisons too, to help you choose the best of the best for your investment money.

Without further ado, let's dig in!

John, from what I understand the first piece to this puzzle has to do with protecting ourselves from losses when things take a turn for the worse. How can investors safeguard against losing all of their investment, or close to it, in banking panics?

John Maxfield: The important thing to keep in mind whenever you're investing in banks is, to your point about banking panics, if you go back and you look at the history of banking, the banking industry more than probably any other industry is really susceptible to these infrequent, intermittent panics that cause a whole bunch of them to fail, or if they don't fail to egregiously dilute their shareholders.

When you're picking a bank stock, the very first thing you want to do is just do a temperature check to make sure that the bank you're looking at is not susceptible to that.

The easiest way to do that is just to look at its annual return on equity over the past, say 10 years. Pick out the lowest annual return on equity. If that number is negative, it means that the bank took relatively large losses in the financial crisis.

If it took large losses in the financial crisis, that means that it probably in some way either underwrites bad loans or takes bad assets onto its balance sheet, and you definitely want to avoid that.

Harjes: How do you go about calculating that number?

Maxfield: There are a couple different approaches you can take to this. First, return on equity, because it's such a common metric, you can just go into a bank's regulatory filings, either 10-Q which is their quarterly regulatory filing, or their 10-K, which is their annual regulatory filing, and you can find all this stuff on the SEC's website, particularly the EDGAR database. You can go in there and just look at their return on equity.

Or, if you wanted to calculate it yourself, what you do is just take their annual net income over any given year, and divide that by the amount of shareholders' equity. That will give you how much they're returning, based upon the capital that's invested in the company.

Harjes: Great. What are we looking to see here? What's considered, in the long run, solid?

Maxfield: As a general rule what you want is a return on equity in excess of 10%.

I say that because in the bank industry it's generally assumed that common capital costs roughly 10% of your equity, so if you want to be moving in a positive direction in terms of your earnings relative to the actual expense of the money that's invested -- when I say the "expense" of the money invested, I mean the opportunity costs associated with investing in a bank, relative to investing in bonds or any other type of investment.

You want to be above 10%, and if you're a really good bank -- a US Bancorp (NYSE:USB), a Wells Fargo (NYSE:WFC), an M&T Bank (NYSE:MTB), a New York Community Bancorp (NYSE:NYCB) -- you're going to be up in the 15% range.

Harjes: And yet, in this 15-minute analysis, what you would recommend is looking for that worst year?

Maxfield: That's exactly right. That's the first step. That is just making sure that you're not going to get yourself into a situation where, in the next downturn or financial panic or whatever it is, you're not going to regret the decision of investing in that particular bank.

Harjes: Right. Even if you have been experiencing pretty good returns during normal times, all of a sudden the economy takes a turn for the worse and you see your entire investment getting washed away.

Maxfield: That's exactly right. Even more to that point, Kristine, is that when the economy is going really, really well, the poorly run banks actually have a tendency to generate really high returns on equity because they're underwriting a ton of loans, many of which will eventually go into default when the economy turns against the banks.

Just looking at the topline return on equity, and how high it is over a given time period, isn't going to tell you as much as looking at the bottom line.

Harjes: Sounds good. There's Step 1; identifying the lowest annual return on equity since 2008. The next step in your 15-minute analysis is taking a look at how disciplined the bank is, and how much of its revenue gets washed away by expenses. John, how do we get a feel for this?

Maxfield: There is a metric in the banking world called the efficiency ratio. What the efficiency ratio does is it just tells you the percent of a bank's net revenue that's consumed by operating expenses.

You're going to want to see that figure be in the 60% range. Ideally, quite frankly, with a really good bank you're going to want to see it below 60%, but if you have a bank that has an efficiency ratio that's above 60% ...

Let's say a bank's efficiency ratio is 75%. That' means that only 25% of its revenue is left over to pay taxes, to take care of dividends to preferred shareholders, and also to take care of loan loss provisions.

That's going to leave very little income left over to accrue to the actual common stock shareholders. You want to see that efficiency ratio relatively low, in order for a bank to be highly profitable.

If a bank is highly profitable, then it's going to compound its earnings at a very rapid rate. Assuming that they are good about their risk management, it will do so over a long period of time.

Harjes: It seems like this is all tied together by the concept of discipline.

Maxfield: That's exactly right.

Harjes: Which banks have the best efficiency ratios?

Maxfield: Your general banks that have great efficiency ratios; I've already mentioned them, Wells Fargo and US Bancorp.

US Bancorp is pretty consistently in the mid-50% range, 55% and a little bit higher. It's trended a little higher over the last few years, just because we have higher regulatory compliance costs as a result of the increased regulation since the financial crisis.


But you also have a bank like New York Community Bancorp; its efficiency ratio is often in the 40% range, between 40 and 50%. That's just because it's got kind of a unique business model.

Those are the banks that are really disciplined, not only at expenses -- and this is something we've talked about in the past -- but also writing good loans. There is a connection there, because it takes discipline to do both.

Harjes: Right, so you get that positive feedback loop, where banks with lower ratios are already more profitable so they have less incentive to make these questionable loans just to stretch out their yield.

Maxfield: That is exactly right. If there's one thing, Kristine, that bank investors should keep in mind, it is that relationship between a bank's efficiency ratio and its tendency to underwrite either good or bad loans.

Harjes: That's a very important Step 2, then, your efficiency ratio. Step 3 is all about profitability. John, what is our last metric to look at?

Maxfield: The last thing you're going to want to look at -- after we've gone through and temperature checked the bank to make sure that it has probably a good chance of making it through the next crisis in good shape, if not even thriving during the next crisis, then making sure that as a general rule it's a relatively highly profitable bank because its expenses take up a relatively small proportion of its net revenue -- then you're going to want to swing in and see how it's doing on the sales side.

To determine that, you're going to want to look at this topline revenue. There are a number of ways that you can look at it, but how I like to look at it is you want to see a topline revenue figure that's somewhere in the range of 4.5% or greater, relative to its assets.

Harjes: Why 4.5%?

Maxfield: If you go through the math ... earlier I said that a bank is going to want to earn, let's say, a 10% return on equity just in order to cover its cost of capital. We can start there, and then work our way backwards.

Because banks are leveraged by a factor of 10:1, that means you're going to want to earn about 1% on your assets. If you take into consideration that you want to get your net income to be about 1% of your assets, then you have to start backing out your expenses.

Let's say 60% of your revenue is consumed by your expenses. That's going to increase how much revenue you're going to need, relative to your assets. Then you've got to take into consideration taxes and loan loss provisions, and the payouts to your preferred shareholders.

Once you take all those things into consideration, the math works out that you need 4.5% or higher in order to generate at least a 10% return on equity.

Harjes: That makes sense, that you're starting with the 10%, you're considering a leverage factor of 10:1. That gives you your 1%, and then you take your efficiency ratio and say that because you do have all these costs, you want to see revenue up there in the 4.0-4.5 or greater range. But how do you get that 10% to start with?

Maxfield: The terminology is used in the bank industry that your 10% is your "cost of capital." What they mean is that, even though when you look at a bank's income statement equity capital doesn't actually have an expense; it's not like you're paying interest on it. However, the way the banks look at it is they impute a cost of capital.

They say, "Look, we have to earn a certain amount of money in order to attract investors to invest in our stock rather than, say bonds, other stocks from other industries," and that type of stuff.

What the industry has settled on that return on equity being is right around 10%, to where over the long run, the bank industry at that rate can sufficiently attract the equity that it needs in order to do what it does.

Harjes: So it's a theoretical interest to shareholders, just so that people don't sell all their shares and cause the price itself to drop.

Maxfield: That's exactly right. It's an imputed cost of capital. It's not actually a cost of capital. It's just imputed.

Harjes: Great! There we have our three steps.

The one thing that's left on my mind though, that we haven't really touched on within those three steps -- what about valuation? How do you know that, even if a bank passes the test on these three metrics, you're not paying too much?

Maxfield: That's a great question. Valuation is tricky when it comes to any type of stock, and banks are no exception. The problem is, if you have a bank that has great credit discipline, great expense management discipline, and it also has good revenue generating abilities, it's going to trade at a high valuation relative to its book value.

In the bank industry the saying is you want to buy at half of book value and sell at two times book value, but the reality is that if you're going to invest in banks, you only want to invest in ones that are stable and that you can trust to make it through the next crisis, and those are good banks.

It's unheard of when a bank like US Bancorp or Wells Fargo is going to trade at half of book value, so if you're going to buy bank stocks, you're going to have to pay up in your valuation.

The one positive thing about that is that good banks -- if you look at, say a US Bancorp, that trades for about two times book value -- if you look at a chart of its valuation over years and decades, it's always traded at a relatively high valuation.

It kind of takes care of itself. It's not like you're buying at two times book value, then it's going to fall down to one times book value. Good banks traditionally stay right around that two times book value rate.

You just have to suck it up, go with it, buy the good banks at a high valuation, and just assume that's going to compound at a high rate, which it should do, particularly relative to their less-well-managed peers.

Harjes: That's a very Foolish answer, John, since of course we do advocate at The Motley Fool buying and holding for the long run!

Maxfield: That's the thing. The one thing that we know is that if you hold stocks, good companies, for a very long time, even if you overpay a little bit you're still going to generate great returns.

That's by Warren Buffett. One of his famous sayings is, "It's better to buy a wonderful company at a fair price, than a fair company at a wonderful price."

Harjes: That's an awesome way to close out the episode! Thanks everyone, for giving us your 15 minutes today. John, thanks so much for sharing your awesome framework.

Of course, picking out a bank that you can really stand behind buying shares in will likely take you more than 15 minutes, but I know I was surprised to hear just how much I could learn about a prospective bank stock in just these three easy steps.

What banks are you guys going to try it out on? What's on your mind? Let us know at IndustryFocus@Fool.com. We love hearing from you guys, and we're happy to answer whatever questions you might have for us.

Until next time, have a great week, Fool on!

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

John Maxfield has no position in any stocks mentioned. Kristine Harjes has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of 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.