If you're new to banking or bank stocks, the term "net interest margin" will come up time and again throughout your research into the industry.
It measures how much a bank earns from the age-old practice of borrowing money from depositors and other types of institutional investors and then investing that money into higher-yielding interest-earning assets like loans and fixed-income securities (principally bonds).
In the most recent quarter, for example, Bank of America's (NYSE:BAC) net interest margin came in at 2.37%.
This is calculated in two steps. The first step is take the difference between what the Charlotte, North Caroline-based bank earned from its $1.8 trillion dollars' worth of interest-earning assets and what it paid out on the debt used to finance the assets.
You can find this information in a bank's regulatory filings (available from the SEC's EDGAR database) contained in a table titled "Quarterly Average Balances and Interest Rates" -- go to pages 22-25 in Bank of America's latest 10-Q to follow along.
For the three months ended June 30, 2015, Bank of America generated $13.4 billion dollars in interest income from its $881 billion loan portfolio and roughly $1 trillion from its portfolio of securities and other assets. To finance these holdings, it paid $2.6 billion in interest expense. The difference between the two, known as "net interest income," is $10.8 billion.
If you then multiply this figure by four -- to reflect the fact that there are four quarters in a fiscal year -- you get $43.2 billion in "annualized" net interest income.
Now that we have this, we can move on to the second step in the analysis. That is, to divide Bank of America's annualized net interest income by its $1.8 trillion in average earning assets. This gives us Bank of America's 2.37% net interest margin.
To say that this is an important metric for bankers and bank stock investors would be an understatement. Even our biggest banks, with their wide diversity of fee-generating businesses, still earn around half their revenue from the difference between their yield on earning assets and their cost of funds.
Bank of America derives 47% of its net revenue from this. Wells Fargo, a more traditional savings and loan operation, gets 53%.
But while the goal of any bank is to maximize its net interest margin, it's important to appreciate that doing so comes at a cost. This is because a high yield on earning assets relative to the industry almost necessarily means that a bank is taking on more risk than its peers.
Additionally, much of a bank's net interest income is a function of short-term interest rate benchmarks such as the London Interbank Offered Rate in Europe or the Federal Funds rate here in the United States. When these are high a typical bank will earn more from its assets than when rates are low.
The latter is where we find ourselves today. Since the financial crisis, the Federal Reserve has kept short-term rates just above 0%. If these increase by only a single percentage point, Bank of America projects that it will earn $4.6 billion more in annual net interest income. This is high margin income because it takes no added expense to generate.
In short, and particularly right now, it's important that bank investors appreciate the role that the net interest margin will play in terms of both profitability and shareholder returns over the foreseeable future.
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 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.