After some costly mistakes I have made investing in bank stocks, I think it is time for me to get an idea of how one can value a bank. I want to at least be able to figure out if the recent pitch given to me by the friendly analyst or a well-wisher has some substance in it.
Instead of doing this superficially for a particular bank, I have decided to learn the ropes of banking valuation. In this regard, I am a fan of Chinese proverbs. They know how to say things mysteriously and succinctly.
Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime. - Chinese proverb
Hopefully, these articles will help you net a particularly appetizing fish when we are finished.
This article will describe what a bank does. Then we will move on to reading the balance sheet of a bank. As an example, I take the balance sheet of one of my holdings, Banco Santander (STD).
I The business
A bank in its simplest form is a business that keeps your money and gives you some interest on it, year after year. As the money cannot reproduce and the inflation is always positive, the bank cannot expect to make money by just keeping it in the vault. So, they lend it out to people to build/finance homes, to businesses to invest in their growth, and in general to borrowers — at a much higher interest rate than they are paying the depositors or people they get the money from.
II The debt
The most basic equation of a balance sheet is that the total assets of a company is equal to the equity, added to the liability. In other businesses we like to see the liability to be much smaller than the equity. For banks the situation is just the opposite. The debt is the raw material that a bank uses to create value.
III Balance sheet
It is particularly difficult to read the balance sheet of a bank. The problem is that it is very different from the balance sheet of a company which produces and sells products. The cash is the byproduct of such companies but for a bank it is both the raw material and the final product. So, you will not see items like inventory, property plant & equipment, trade receivables. Instead, you will see provisions for loan losses, trading portfolio, investments and so on. Let us look at these items one by one.
The assets of a bank are anything that can be sold for a value. This could be the building which the bank owns. But, hard assets like buildings and real estate, are a very small part of a bank’s balance sheet. Below I give the asset side of the balance sheet of Banco Santander (STD). Let's look at it in more detail.
The basic service of a bank is to provide cash to its customers, be it a depositor withdrawing money, a business using its credit line to get some extra cash or a customer wanting a loan to finance his new house. A bank also needs cash to pay its employees, for electricity/rent, and for acquisitions and investments in its business. The bills that the bank needs to pay and acquisitions it wants to make are predictable and hence can be planned for, but the cash withdrawals by its customers are not. A bank which cannot pay money to its depositors when they need it will be either forced to sell its assets or declare insolvency.
Obviously, the government does not want fraudulent people to open banks and declare insolvency. So, every country has a central bank whose function is to manage the nation’s monetary policy. Every functioning bank has a cash account with the central bank (called reserve). The central bank decides on a legal reserve lower limit (generally a percentage of the total liabilities the bank has) and the bank has to maintain a cash reserve with the central bank which is above this limit. When the risk goes up the central bank may increase this legal reserve limit. Conservative banks often keep excess reserve for more safety.
Generally, when one looks at a bank’s balance sheet, the cash represents a very small part of the total assets. For example, in case of STD it is 7% of the total assets. This is even a bit high than a lot of banks at the moment. Well Fargo (NYSE:WFC) has $19.4 billion in cash and $44.4 billion in federal funds, which is less than 6% of asset of $1,313 billion.
Banks do not like to tie their money to fixed income securities (like U.S. Treasuries) because the yield is not very good (fixed income securities is a type of investment that pays a fixed interest rate and returns the principal when it matures). Instead, they like holding investment grade securities that yield higher returns but are still quite safe and very liquid. An example would be municipal bonds.
U.S. banks are not permitted to own stocks because of the risks associated with them but ironically they are allowed to own a much riskier class of assets called derivatives. Derivatives include instruments like forwards, futures, options, warrants and swaps. Because of the lack of transparencies derivatives can cause major damage to a bank’s balance sheet in case of unforeseen circumstances. It also makes it hard for us investors to come up with a value for the bank if it is largely invested in the derivative market.
For STD derivatives are 8% of the total assets and and debt securities are around 5% of the total assets.
Loans are the major assets for most of the banks. They earn more interest than the securities the bank owns and are a major source of revenue. Loans come in different varieties, like business loans, asset backed loans, mortgages, credit cards, auto loans and interbank loans. The loans are the assets of the bank and are as real as say steel is for steel manufacturers. A bank can sell a group of loans to a different bank for a price. It can also sell it to investors and earn a fee on putting together this investment.
The loans come with a lot of risk too. If the bank makes bad loans to either individuals or businesses and they are not paid then the bank will have to write it off as losses and the earnings will take a hit. In fact, if the bank makes too many of these loans, it may find itself insolvent. This is why we need to look at the business model of the bank and the management. We need to ask if the business model has been successful in the past and has the management made loans to questionable people or businesses. We need to find out the percentage of loans that have not been repaid.
As we see, loans represent 62% of the assets for STD. The notes attached to the financial statement will have more details about these loans. It will tell you if the loans are backed by physical assets like homes, malls, land or not. An asset backed loan is less risky because in case of default the underlying assets can be sold and the bank will not suffer a big loss on it.
Now we come to the other side of the coin. The liabilities of a bank. As we saw earlier, a bank needs money to make loans. The liability side of the balance sheet lists these sources and tells you how much money comes from where.
These are the best and the cheapest source of funds for a bank. A big customer base with copious amount of cash is the best thing that can happen to a bank. The interest the bank needs to pay on these accounts is very small and it is a very cheap source of money to be invested in growing the bank. A good bank will have a lot of deposits financing its assets.
If we compare STD and WFC, we see that deposits finance 47% of the assets of STD but a whooping 70% for WFC. I see now one of the reasons Warren Buffett likes Wells Fargo (NYSE:WFC). It has a huge customer base and hence access to cheap financing for its assets.
A bank can borrow money. The source of these funds are many. It can borrow money from other banks in the federal funds market. We talked about the Federal reserve before. This is a cash account of the bank at the central bank. It is supposed to keep cash which is a percent of its liabilities in turn to alleviate the risk of it going broke. Bigger banks have more venues to spend cash than the smaller community-oriented banks. This means that the smaller banks have generally excess reserve and the bigger ones can borrow money from the smaller ones and pay interest on them. The problem is that these loans are not secured. If the bank you loaned the money to goes poof then there is nothing you can do. So, the bank with excess reserve loans the money to a bank it trusts. If there is a lack of trust between banks (something that happened during 2008-2009), the banks avoid loaning money to each other and the supply of money going in the economy is restricted.
Banks also borrow money from insurance companies and pension funds where the funds are non-depository in nature. These loans are generally collateralized against Treasuries or securities. These are called repurchase agreements (repo) and are mostly overnight. The funds are returned the next day with the interest.
A bank can also borrow money from the central bank. This is frowned upon in the banking industry because it means that the bank might be in trouble.
Banks do not like borrowing from other sources than the deposits, mainly because these borrowings cost a lot more than the deposits.
Banks also get funds from the owners of the common/preferred stocks. A bank can issue shares to get more funding (something that happened during the credit freeze in 2008-2009). This is part that the shareholders put in to finance the assets the bank owns.
After paying their depositors and the creditors a bank earns around 1% on their assets. If the assets are financed by only equity than you would get in the best case 1% return on your investment and no one will then invest in a bank. This means that to get a satisfactory return on the equity the bank needs to leverage its balance sheet. You will see that for every dollar of the equity, the bank will have something around $10 in assets.
For STD this figure stands at 15, i.e., for every dollar of equity STD has $15 in assets.