Get Pumped (and Educated) About Bank Earnings

Third quarter earnings results will be published soon. Here's a quick primer on how to find reports, what to look for in them, and an example of how to prepare.

A full transcript follows the video.

Gaby Lapera: Hello, everyone. Welcome to The Motley Fool's Industry Focus, financial edition where we try to make jokes about finance and they almost never work.

This week we're going to have a super interesting episode because we're going to be talking about bank earnings, which is everyone's favorite topic. In order to kick us of we're going to talk a bit about how banks work and how to analyze bank earnings. Banks, at their most basic, borrow money at a lower interest rate than they lend it out.

John Maxfield: That's exactly right. For brand new investors, every quarter publicly traded companies report earnings to give their shareholders an update on what's going on. The first question is: where do you get that information? Secondly, what do you look for when these companies report? Some of their earnings releases are around 60 pages long.

Lapera: Absolutely. Especially the big ones.

Maxfield: That's right. Wells Fargo (NYSE: WFC) has around 90 different business lines and you've got to go through each one of those to give your shareholders all that information.

Lapera: Right. Luckily for investors it's really easy to get this information. If you want to get the earnings reports all you have to do is go to the bank's investor relations site and it should be right up there at the top as soon as they publish it. The other part of this that I think some people might not know about is there are also call transcripts where the CEOs discuss the earnings for that quarter.

Those are also easy to find. I'll plug our competitor here. Seeking Alpha almost always has call transcripts and it's worthwhile to go through them yourself.

Maxfield: I agree 100%. If you could get that earnings release from the banks, or whatever company's investor relations website, you read through that, or pick through it and then look at the conference call transcript; you should have a really good idea about what happened in the previous quarter.

In terms of bank earnings, the first number you're looking for is your return on equity. You want that to be in excess of 10%. On this show we've talked a lot about why that is, but it's basically because if a bank is earning more than 10% of return on equity then it's creating value. If it's not earning that much then it's destroying value.

You want to start there and then work your way backward through revenue, expenses, and loan loss provisions to figure out why it's exceeding that target if it is, in fact, exceeding that target. If it's not, you can tease out why it's not.

Lapera: Exactly. When you're doing this, although it's important to have the numbers, the numbers by themselves don't mean anything. Something you have to keep in mind is that each bank has a story. That story is particular to that bank and that means the numbers need to be understood in the context of that story.

Additionally, banks don't exist in a vacuum. There's not just one bank. We have multiple banks so you have to understand what's going on with the industry as a whole to understand exactly what's going on with one bank.

Maxfield: That's a fundamental point that investors need to appreciate, particularly in the aftermath of the financial crisis. You have Bank of America who, even though it's made considerable strides over the last few years, it's still making its way out of the hole it dug before the financial crisis; particularly because of the Countrywide Financial situation.

So you'll want to look at how high the expenses are, what its credit quality looks like, if there's an independent unit that it put bad assets into during the financial crisis and reducing that ever since; where are they at in that regard? Then if you look at Wells Fargo on the other hand, where Bank of America is a progress report from its recovery from the financial crisis, Wells Fargo didn't need to recover from the financial crisis.

What you'll want to look for in a bank like that is slow and steady loan and deposit growth, wide margins, return on equity, how the net interest margin is doing; all those things. To Gaby's point, when you're looking at these banks and analyzing these earnings it's not just a mechanical approach. You've also got to have some context around where these companies are right now to really draw out the substance of those numbers.

Lapera: Absolutely. As an example, let's dig a bit deeper into Bank of America (BAC -0.13%). They had a giant expense in legal issues, which has presumably gone down considerably since that court case cleared in New York.

Maxfield: Right. The big thing with Bank of America -- and I know we talk about Bank of America a lot on this show, but the reason we talk about it is because it is the most heavily traded stock on the New York Stock Exchange, by far. It is owned by a large slot of individual investors.

Other than Apple and stuff like that, Bank of America is one of the most popularly owned stocks in the country right now. When you're talking about Bank of America in particular you're going to want to look at a couple different things.

Number one: their stress test is coming up on September 30^th. They had to resubmit their proposal of how much capital they're going to increase, or return to shareholders over the next year. That's normally submitted in March. They submitted on in March, but then they had some issues so they had to resubmit it by September 30^th. You're going to want to listen to any color they provide around that.

In the second quarter of this year, Brian Moynihan really switched from defense to offense. The question is: did he do it prematurely, or are they really on the offense now? You'll want to listen to his conversation about whether he's still focusing on expenses, or if he's really shifted over to try and figure out how to grow revenue.

Lapera: When you say "switch from defense to offense", before Bank of America had a lot of legal issues to deal with. They had a lot of assets that weren't preforming. That was when Bank of America was working defensively. In some of the more recent call transcripts Brian Moynihan has been reacting more offensively and talking more about how to raise revenue instead.

Maxfield: That's exactly right. If you look at Bank of America's numbers, when you normalize it for size -- like Wells Fargo being a notoriously efficient bank -- in the second quarter, their expense bases were pretty much even. It was now the revenue that Bank of America trails so far behind Wells Fargo and J.P. Morgan (NYSE: JPM). That's why its return on equity is so much lower than those other banks.

Lapera: Yeah. A lot of the banks are also having an interesting quarter, especially the big ones. I think one of the things we talked about before was that the Fed didn't raise the interest rate. In this low interest rate environment, a lot of the banks are saying that their revenue is going to be down because they can't make as much on loans.

Maxfield: Right. This is a point you brought up at the beginning of the episode. One way that banks make money, particularly big banks that generate half their revenue from it, is they go out and borrow a bunch of money and then pay really low interest rates to their depositors or institutional investors. They take that same money and invest it in higher interest earning assets.

When you arbitrage your lower interest rates against your higher interest rates you're going to make a lot of money there, particularly when you consider that most banks are leverage by a factor of 10:1. One of the problems in the aftermath of the financial crisis is that interest rates have basically never been this low for this long before, in the history of the United States. At least not that I can see when you take the data back as far back as you can go.

That is putting a lot of pressure on the profitability of those asset portfolios, which is reducing revenue. That's just another thing that's sort of the same thing we've seen for the past few quarters. The question is: is the revenue still on a downward trend for the industry as a result of that, or has it turned around a bit, or leveled out?

Lapera: Right. Just to tie this back in the beginning of the episode: This is what Maxfield and I meant when we said that you needed to understand what was going on with the industry as a whole, as well as what was going on with the bank.

Maxfield: Exactly. A lot of people talk about what's going on with interest rates and this is why it matters for banks. Two more things that you'll want to watch for in terms of the industry overall are trading -- all the big banks that have large trading operations like J.P. Morgan Chase, Bank of America and Citigroup (NYSE: C) all came out in the last few weeks and said that given everything that's gone on in the most recent quarter, volatility was down, volume was down, their trading income was going to be at 5% or 6% lower.

That doesn't mean that revenue was going to be 5% or 6% lower because trading only makes up between 5% and 10% depending on the bank's overall revenue. That's just another thing to keep in the back of your mind when you see these figures start to come out.

The last thing is, anytime you're talking about banks, the underlying engine is loan and deposit growth. You always want to see if one bank is growing its loans and deposits in line with its competitors and in line with previous trends. If it's not you then dig into the reasons why, or why not.

Lapera: Thank you. I think this was a very complete overview and we gave people an idea of how to think about earnings coming up. I want to remind our listeners that as always, people on the program may have interests in the stocks they talk about and The Motley Fool may have recommendations for or against. So don't buy or sell stocks based solely on what you hear. Thank you very much for joining us and have a great day!