I've come to the opinion over the years that the efficiency ratio is the single most important metric for individual investors to analyze before buying a bank stock. The problem is that it isn't a term most investors know off the top of their heads.
It's for this reason that I wanted to take the opportunity to talk specifically about this particular metric. What is the efficiency ratio? How do you calculate it? And why is it such a critical component in the analysis of bank stocks?
To be clear from the outset, this is a straightforward concept. You don't need a master's degree in finance or years of investing or banking experience to fully grasp what it is and why it matters.
It's nothing more than a bank's operating costs, referred to on a bank's income statement as "noninterest expenses," divided by its net revenue (a bank's total revenue less interest expense).
In the most recent quarter, for example, the notoriously efficient US Bancorp's unadjusted efficiency ratio was 53.7%. (To see exactly how this is calculated, click on this link to go to US Bancorp's second-quarter earnings release. Now head to page 28, where you'll find the bank's income statement.)
To calculate its efficiency ratio, we need to do two things. First, add US Bancorp's net interest income for the three months ended June 30, 2015 to its noninterest income. This gives us $4.99 billion in net revenue ($2.72 billion in net interest income plus $2.27 billion in noninterest income). Then, divide US Bancorp's noninterest expense of $2.68 billion by its net revenue of $4.99 billion. This gives us an efficiency ratio of 53.7% -- which is really good, as the objective is to get as close to 50% as possible.
This number is important for two reasons. First, it tells us roughly how much of a bank's net revenue will be available to (1) set aside for future loan losses (these are known as "loan loss provisions"), (2) pay taxes, (3) distribute to shareholders via dividends or stock buybacks, and (4) fall to the bottom line of a bank's balance sheet and thereby fuel its book value.
The fourth point is particularly important because a bank's book value per share weighs heavily on the price of its stock. All else equal, a bank with a high book value per share will have a correspondingly high share price. And vice versa.
The second reason the efficiency ratio matters -- and, to be clear, a lower ratio is better than a higher ratio -- is because there seems to be a correlation between a bank's efficiency and its tendency to underwrite good loans. That is, efficient banks generally have to charge off fewer loans than inefficient banks.
Thus, the efficiency ratio packs a double punch. Not only does it correspond to lower operating expenses, it also corresponds to lower loan losses. And it's for these reasons that I believe the efficiency ratio is the single most important metric when it comes to investing in bank stocks.