It's no wonder Warren Buffett loves bank stocks. The legendary billionaire investor has almost $50 billion of his $228 billion Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) invested in this one industry.

The reason is simple: Bank stocks possess many of the Buffett must-haves. First, banks serve an important societal need that will never go away. Second, banking business models are relatively simple to understand. Third, despite the health of many banks improving dramatically since the 2008 financial crisis, some bank stocks are trading at a bargain -- a key indicator that now is the best time to invest.

Let's examine the basics of bank stock investing, the history of bank stocks, and how to find one worth investing in.

Tall bank buildings in financial district

Image source: Getty Images.

What are the different types of bank stocks?

Generally, there are three different types of banks:

Commercial banks

Commercial banks are what most people think of when they hear the word bank, which are those making money by taking in customer deposits and then lending the vast majority of the cash to borrowers. Wells Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB) are two of the biggest commercial banks.

Investment banks

Investment banks such as Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS) mainly provide financial services to corporations, companies, and governments. They also provide services such as facilitating complex financial transactions, advisory services, stock trading, and asset management. Investment banks also guide companies through their initial public offerings (IPOs).

Universal banks

These banks offer both commercial banking and investment banking services -- think Bank of America (NYSE:BAC), Citigroup (NYSE:C), and JPMorgan Chase (NYSE:JPM). They offer the advantages of a diversified revenue stream and international scale. They also come with the risks of both commercial and investment banking and are more complex businesses to understand.

Top three bank stocks by market cap

JPMorgan Chase

The largest U.S. bank by assets, JPMorgan Chase (NYSE:JPM) was formed in 2000, although its earliest predecessor institution, The Manhattan Company, was founded in 1799. With assets of more than $3.2 trillion, JPMorgan focuses its core business on community banking, investment banking, and wealth management.

Under the leadership of CEO Jamie Dimon, JPMorgan managed to emerge from the global financial crisis in better shape than its peers. Sensing the growing default risk, the company largely stayed away from the toxic subprime and derivatives markets, a move that brought criticism for being too conservative. Even though JPMorgan didn't escape completely unscathed, it was the only megabank to remain profitable throughout the downturn.

Bank of America

Bank of America (NYSE:BAC) is second to JPMorgan, with more than $2.7 trillion in assets. Unlike JPMorgan, the company was bruised and battered by the financial crisis after two notable acquisitions that brought years of costly litigation and cost tens of billions of dollars in losses. CEO Brian Moynihan, who took over in 2010, has led one of the most dramatic turnarounds in banking history.

No longer a bloated regulatory nightmare, BofA is arguably the best-run of the biggest banks, and the steady improvement in its return metrics supports this. Buffett is certainly a big fan, having made Bank of America easily the biggest bank in Berkshire's portfolio.

Wells Fargo

Wells Fargo (NYSE:WFC) has a great track record of strong lending results across economic cycles. Wells was remarkably stable throughout the Great Recession, taking a conservative approach to loan and deposit growth and avoiding risky investments. Historically, it's been one of the best banks at managing through crises, a big reason Buffett long made it a featured holding in the Berkshire portfolio.

But the fallout from the fake accounts scandal that damaged the bank's reputation and led to the ouster of its CEO has plagued the company and made Buffett a seller. It also led to severe restrictions from regulators, including a prohibition on growing its assets above $1.95 trillion (with some exceptions tied to federal lending programs during the coronavirus recession), a brutal restriction in the midst of record-low interest rates and a booming housing market.

How to calculate profitability ratios for a bank

Since many banks generate profits from lending activities, it's important to know which financial metrics paint the best picture of how profitable a bank really is.

Here are four key profitability metrics for analyzing traditional bank stocks:

Profitability Metric

How to Calculate

Ideal Benchmark

Return on equity (ROE)

Net income ÷ Total shareholder's equity x 100

At least 10%

Return on assets (ROA)

Net income ÷ Total assets x 100

At least 1%

Net interest margin (NIM)

Net interest ÷ Total interest generating assets x 100

At least 3%

Efficiency ratio

Noninterest expense ÷ Net revenue x 100

60% or lower

Return on equity

Return on equity (ROE) is how much profit a company generates as a percentage of shareholders' equity, or the amount that would be returned to shareholders if all assets were sold and debts repaid. The higher the ROE, the more efficiently a company is putting shareholder equity to work. 

Return on assets

Return on assets (ROA) is the percentage of overall profit, or net income, a company makes relative to its total assets (which include interest-earning loans, securities, cash, etc). 

Net interest margin

Net interest margin (NIM) is the difference between the interest a bank receives on loans and the interest it pays on deposits. NIM tends to move in tandem with interest rates. As interest rates rise, so do bank interest margins; conversely, falling rates generally lead to smaller net interest margins.

As a general rule, you shouldn't look at net interest margin as a stand-alone metric but understand a bank's net interest income and expenses -- in particular, how successful a bank is at maintaining low-interest-yield deposit customers during rising-rate environments.

Efficiency ratio

Efficiency ratio measures how much of a bank's revenues go toward covering operating costs. Unlike with the metrics above, where a higher number is better, a lower efficiency ratio is what you want to see. This should lead to higher returns and profitability since lower expenses mean more money left to lend or otherwise invest.

How to assess a bank's risk

Banks are incredibly leveraged businesses, lending out 90% or more of the deposits they get from customers. As a result, a bank's ability to perform as an investment is heavily tied to its ability to minimize loan losses, particularly during economic downturns.

Here are two important bank risk metrics:

Nonperforming loan ratio

Nonperforming loans (NPL) are loans that are at least 90 days past due and approaching default. The lower the percentage of bad loans, the better. A NPL ratio above 2% can be cause for concern.

Net charge-offs

A charge-off is a declaration by the bank that money lent out is unlikely to be collected. Generally such a declaration is made about a delinquent debt that has gone over six months without payment. The net charge-off rate, which is net charge-offs divided by total loans, represents the percentage of total loans unlikely to be paid back. This metric is particularly important to watch for banks with large unsecured debt, such as credit card debt, especially during economic downturns.

Valuing a bank stock

Price-to-earnings (P/E) ratio is a helpful metric for understanding how expensive a stock is relative to its earnings. But for bank stocks, the price-to-tangible book value (P/TBV) ratio is also very useful. P/TBV measures how much a bank is trading at relative to assets such as property, cash, and the loans in its portfolio. This is in contrast to the price-to-book (P/B) ratio, which also includes intangible assets such as patents, brand names, and goodwill. The P/TBV metric strips away intangible assets and focuses on the tangible assets that drive a bank's earnings and underpin its value.

A number of factors can affect the earnings and book-value multiple investors are willing to pay for a bank. A good rule of thumb is to focus on the best-quality banks and invest in them when shares trade for a solid discount to their historical valuations. It's also important to compare banks to similar peers since differences in banking services, operating models, and profitability metrics can result in one bank consistently trading for a higher -- or lower -- valuation than dissimilar peers.

Key trend to watch: The rise of fintech

Banks aren't known as beacons of innovation. Their slow processes, high fees, and sometimes questionable lending practices have created an industry ripe for disruption. Fintech (the term is short for financial technologies) could do just that. Fintech includes a broad array of applications, many of which banks have already started adopting such as chip-enabled card systems and mobile banking apps. But the real pressure comes from newer, more innovative approaches to how consumers bank: peer-to-peer (P2P) lending and payments, robo-advisors, and brokers offering cheap stock trades.

Whether fintech will completely overhaul the banking business model is up for debate. What we do know is that fintech firms are forcing banks to either step up their game or risk becoming obsolete.

Dividends

Bank stocks can be solid dividend investments, with the caveat that they're very leveraged and heavily tied to the ups and downs of the economy. As a result, banks can go for years, paying and increasing a steady dividend, only to have the payout wiped out when there's an economic downturn or banking crisis. That's particularly true for the largest banks, which face more stringent regulation. Wells Fargo, for instance, was required to cut its payout more than 80% in 2020 due to concerns about its financial condition.

Owning a few of the top banks as part of a dividend portfolio is likely to prove a sound strategy as long as your holdings are diversified.

Is now a good time to buy bank stocks?

2020 was not a good year for bank stocks; most are down by double digits, while the S&P 500 surged back quickly from the coronavirus crash in March 2020. On one hand, it makes sense for many bank stocks to be down. Between the collapse of the consumer economy and interest rates plummeting to all-time lows, the risks are higher and profits are lower. 

But, if history is our guide, it seems recent valuations should result in great returns. Many of the top banks, including JPMorgan, U.S. Bank, and Bank of America, trade for price-to-tangible book value multiples that are 20% or more below pre-coronavirus levels. Moreover, the extended housing boom we may see as millennials move into the home-buying market over the next decade could drive bank assets and profits higher for many years to come.

If they're still trading for that steep a discount when you read this, then it's probably time to put the top bank stocks in your portfolio.