Bank stocks might seem intimidating to analyze, but the reality is that the banking business is easier to understand than you might think. And banks are similar enough that once you learn how to analyze one, you're pretty much set to analyze the rest.

While the business dynamics of any particular bank are obviously more complex than we can explain in a sentence or two, at their core banks borrow money at one interest rate and then lend it out at a higher interest rate, pocketing the spread between the two.

When trying to analyze a particular bank stock, it's a good idea to focus on four main things:

  1. What the bank actually does
  2. Its price
  3. Its earnings power
  4. The amount of risk it's taking to achieve that earnings power

Let's take a look at each of these and how to incorporate them into your bank stock research.

Exterior of a bank building.

Image source: Getty Images.

What the bank actually does

There are three main types of banks:

  1. Commercial banks: Those that primarily make their money by lending to customers and profiting from their interest margin.
  2. Investment banks: Those that advise clients on mergers and acquisitions (M&A), facilitate equity and debt offerings, manage wealth for high-net-worth clients and businesses, and more.
  3. Universal banks: Those that are a combination of the other two.

There are three things you need to look at to get a feel for what a bank does -- its assets and liabilities (which can be found on its balance sheet) and its income statement.

Assets

In banking, you are your assets -- the loans you make and the securities you hold. They're the things that will drive future profitability when they're chosen carefully, and they're the things that will force you to fail (or get bailed out) if you get in trouble.

The first step is to take a look at a bank's balance sheet.

Loans are the heart of a traditional bank. The greater a bank's loans as a percentage of assets, the closer it is to a traditional savings and loan. For example, a quick look at U.S. Bancorp's (NYSE:USB) balance sheet from the fourth quarter of 2021 shows total assets of $573.3 billion and loans of $312 billion, meaning that 54.4% of the bank's assets are loans. This makes sense because U.S. Bancorp focuses much more on traditional consumer banking than many of its big-bank peers. 

On the other hand, some banks are more focused on investment banking. On Goldman Sachs' (NYSE:GS) balance sheet from the same period, we can see that just 10.8% of its assets are loans.

If a bank isn't holding loans, it's most likely holding securities. There are many possible reasons for this. For example, its business model may not be loan-driven, it may be losing loan business to other banks, or it may just be conservative when it can't find favorable loan terms. In any case, looking at loans as a percentage of assets gives you questions to explore more deeply.

The next step is looking at what types of loans a bank makes. Is it primarily a mortgage lender? A small-business lender? Does it have a lot of auto loans? Or does it focus mostly on credit card lending like Capital One Financial (NYSE:COF)? You should be able to find this information on the bank's balance sheet or in its most recent earnings release.

Liabilities

In banking terms, liabilities generally refer to the deposits that customers (like you and me) put into bank accounts.

Deposits are great for banks for the same reason that you complain about getting low interest rates on your checking and savings accounts. Via these deposit accounts, you're essentially lending the bank money cheaply. If a bank can't attract a lot of deposits, it has to take on debt (or issue stock on the equity side), which is generally much more expensive. That can lead to risky lending behavior -- e.g., chasing yields to justify the costs.

Deposits can be further broken down into interest-bearing and non-interest-bearing. If a bank can attract a large number of non-interest-bearing deposits (common in checking accounts, for example), it can be a major cost advantage over peers.

One important metric to use is the deposits/liabilities ratio. If a bank's deposits make up a high percentage of its total liabilities, it's a good sign that the bank has tons of access to low-cost capital. On the other hand, if more of its liabilities are in the form of debt, it could indicate an unfavorable cost structure and more risk. Looking at one example, U.S. Bancorp's deposits make up 80% of its liabilities -- a very healthy capital structure.

Income

There are two main categories of bank income -- interest income and noninterest income. Interest income is self-explanatory, but noninterest income can take several forms. Banks collect origination fee income on mortgages, service charges on deposit accounts, investment banking fees, payment processing fees, and much more.

Banks report their net interest income, which is the difference between the interest they collect and the interest they pay on deposits. Noninterest income is everything else. Banks generally break this out line by line on their income statements, and you can get a good feel for how a bank makes its money.

There's no right or wrong mix of interest and noninterest income. This is just an important step in understanding how a particular bank's business works.

Its price

The obvious goal when buying bank stocks (or any stocks, for that matter) is to buy them for less than their actual value. But this is much easier said than done, or we'd all be rich!

When it comes to banks, two important valuation metrics to know are book value and tangible book value.

If you're unfamiliar with book value, it's just another word for equity. If a bank is selling at book value, that means you're buying it at a price equal to its equity (its assets minus its liabilities).

To get a little more conservative than price/book ratio, we can look at the price/tangible book value ratio. As its name implies, this ratio goes a step further and strips out a bank's intangible assets such as goodwill. Think about it: A bank that wildly overpays to buy another bank would add a bunch of goodwill to its assets -- and boost its equity.

By refusing to give credit to that goodwill, we're being more conservative in what we consider a real asset (after all, you can't sell goodwill in a fire sale). Hence, the price-to-tangible-book-value ratio will always be at least as high as the price-to-book ratio.

However, you can't determine if a bank stock is cheap or expensive just by looking at its book value. If you could, it would be as easy as simply investing in the bank stocks with the lowest price/book ratios and calling it a day. As with any company, the reason you'd be willing to pay more for one bank than another is that you think its earning power is greater, more liable to grow, and less risky.

Its earnings power

The metric that bridges that gap between book value and earnings power is called return on equity (ROE). Put another way, return on equity shows you how well a bank turns its equity into earnings. Generally speaking, a ROE greater than 10% is considered good, and higher is better. And higher ROE numbers can justify a higher price/book valuation.

Breaking earnings power down further, you can look at net interest margin and efficiency.

Net interest margin measures how profitably a bank is making investments. It takes the interest a bank makes on its loans and securities, subtracts the interest it pays on deposits and debt, and divides it all over the value of those loans and securities. Higher is better. 

While net interest margin gives you a feel for how well a bank is doing on the interest-generating side, a bank's efficiency ratio, as its name suggests, gives you a feel for how efficiently it's running its operations.

The efficiency ratio takes the noninterest expenses (salaries, building costs, technology, etc.) and divides them into revenue. So the lower, the better. Think of the efficiency ratio as how much the bank spends to generate its revenue. An efficiency ratio of 60% implies that a bank pays $0.60 for every $1 in revenue. So you'd obviously like this metric to be as low as possible.

The amount of risk it's taking to achieve that earnings power

Like most other companies, banks can potentially make more money by taking on more risk.

There are a lot of ratios that try to measure how risky a bank's balance sheet is. But one of the simplest and most effective for investors to use is assets/equity. You can find both of these numbers on a bank's balance sheet. For a bank, a general rule of thumb is to look for a ratio that's at 10 or lower.

Getting deeper into assessing assets, we need to look at the strength of the loans. Let's focus on two metrics for this:

  • Bad loan percentage (nonperforming loans/total loans)
  • Coverage of bad loans (allowance for nonperforming loans/nonperforming loans)

Nonperforming loans are loans that are behind on payment for a certain time (90 days is usually the threshold). Those are bad for obvious reasons.

As with most of these metrics, what counts as a reasonable bad loan percentage really depends on the economic environment. But this percentage can give you a sense of how risky a bank's loan portfolio is relative to its peers.

Putting it all together

We've left out many metrics and concepts, but you've still been bombarded with a lot of valuable information that can help you find the best bank stocks to invest in. It's easy to get lost in the minutiae of analyzing a bank, but going in with a framework helps you keep your eyes on the big picture.