How to Analyze Bank Stocks

What the bank actually does

There are three main types of banks:

1. Commercial banks primarily make their money by lending to customers and profiting from their interest margin. Commercial banks offer products like checking and savings accounts, mortgages, auto loans, and other banking products focused on consumers and small businesses.
2. Investment banks advise clients on mergers and acquisitions (M&A), facilitate equity and debt offerings, manage wealth for high-net-worth clients and businesses, and more. For example, when a company decides to go public, they'll consult with investment banks to underwrite their initial public offerings (IPOs).
3. Universal banks are a combination of the other two.

To be clear, every bank is different. Some specialize in certain types of lending or focus on certain types of clients.

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

Price and valuation

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 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). So 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 stock than another is that you think its earning power is greater, more liable to grow, and less risky.

Earnings power

The metric that bridges the 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, an 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 the risks of a bank's balance sheet. But one of the simplest and most effective for investors to use is assets/equity ratio. 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 of 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. In a recession, it's reasonable to expect a bank's loan delinquency rate to rise significantly. But this percentage can give you a sense of how risky a bank's loan portfolio is relative to its peers.

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