How do normal investors like you and I invest in a bank? According to Warren Buffett (Trades, Portfolio), the answer is pretty simple. Look to the bank’s return on assets or ROA.
“Well, a bank that earns 1.3% or 1.4% on assets is going to end up selling above tangible book value. If it's earning 0.6% or 0.5% on the asset, it's not going to sell. Book value is not key to valuing banks. Earnings are key to valuing banks. Now, it translates to book value to some extent because you're required to hold a certain amount of tangible equity compared to the assets you have. But you've got banks like Wells Fargo (WFC, Financial) and US Bancorp (USB, Financial) that earn very high returns on assets, and they are at a good price to tangible book. You've got other banks that are earning lower returns on tangible assets, and they're going to sell – they're going to sell [for less].” – Warren Buffett
The attraction of return on assets is its simplicity. It captures so much of the essence of a bank, without getting caught up in the complexity of the big bank accounting mess.
In our continuing series of discovering the formulas and ideas to value a bank or financial institution, we will discuss the return on assets or ROA.
Definition of return on assets
So what is a return on assets?
According to Investopedia:
“Return on assets (ROA) is an indicator of how profitable a company is about its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings.”
This term is often referred to as return on investments (ROI).
Return on assets tells you what earnings were created from invested capital or assets. Return on assets can vary from the company and will depend on the company's industry.
This is why when using return on assets as a comparative measure, it is best to compare it to a company's previous ROA or the ROA of a similar company.
The assets comprise debt and equity of a company; both of these types of financing are used to fund the operations of the company.
The return on assets figure gives the investors an idea of how effectively the company is converting the money it has to invest in income.
Obviously, the higher the better because the company is earning more money on fewer invested dollars.
Management’s most important job is to make good choices when allocating its resources and the best managers are great capital allocators.
These allocators can create more assets from the assets they already have and create more income for the company from those assets.
How it impacts valuations of banks
When calculating return on assets for a bank, we need to remember that banks are highly leveraged so a 1% ROA indicates huge profits.
The discrepancy catches a lot of investors off guard; you need to remember that these numbers should be used to compare itself to other banks, not a tech company.
That comparison is not apples to apples.
The major assets of a bank are its loans to individuals, businesses and other organizations and the securities that it holds. Its liabilities are its deposits and the money that it borrows, either from other banks or by selling commercial paper in the money market.
Banks can increase their profitability by using leverage and profits can be measured by return on equity or return on assets.
Because of leverage, banks earn a much higher return on equity than they do on assets.
“In the first quarter of 2016, all financial institutions insured by the FDIC, which includes most banks, earned an average return on assets equal to 0.97%, whereas the return on equity was 8.62%.” – Thismatter.com
This chart from the St. Louis Fed Reserve Web site will help illustrate the return on assets across the banking industry for the last 33 years.
As you can see after dipping down during the financial crisis, it has been fairly flat for the last six years. Before the crisis, the ratio was higher, but the banks were using leverage at dangerous levels, which helped fuel the crisis.
The return on equity is what the bank's owners are primarily interested in because that is the return that they earn on their investment, and depends not only on the return on assets but also on the total value of the assets that earn income.
To purchase more assets, a bank needs to pay for it either with more liabilities or with bank capital. Therefore, if the owners want to earn a greater return, they would rather use liabilities than their capital because this greatly increases their return.
When a bank increases its liabilities to pay for assets, it is using leverage –Â otherwise, a limit to bank's profit would be the fees that it can charge and its interest rate spread.
Now on to the formula.
Formula for return on assets
The formula is fairly easy and straightforward to calculate.
The numbers come from two different places –Â the income statement and the balance sheet.
They are easy to find and plug into our formula to find the return on assets for our financial companies.
Return on assets = net income / total average assets
Let’s lay that out a little bit so we understand what these terms mean.
Net income
- Net income is the company's total profit, calculated by taking revenues minus the costs of doing business such as depreciation, interest, taxes and other expenses.
- For banks, the income comes from interest income or loans, securities and such. Add to this the noninterest income such as fees and you arrive at the income portion.
- The expenses for banks are interest expenses from deposits and loans, and the more normal expenses like salaries, benefits, equipment and so on.
- Breaking down bank net income can be more complicated than nonbanking companies, but it is all laid out in the income statement for you to decipher.
- Also referred to as the bottom line to help give you some context.
Total average assets
- The bank's total assets comprise of shareholder’s equity plus liabilities.
- These are the tools the bank uses to generate more equity for the business.
- We take the average of the assets from the fiscal year by using the assets from the current year and the previous year. Both can be found on the balance sheet.
- The total assets can be a little confusing because this number can come from either the asset side or the liability side. But with banks, the shareholder’s equity and liabilities are what drive the creation of more assets. They need the cash, loans from other banks to make these assets.
Something to be aware of about return on assets. Like return on equity, you calculate return on assets with only one year’s data. It can lead to fluctuations in the ratio, drastically if there are any upheavals in the business, such as earnings or business cycles.
Let’s take a look at some examples of this formula in action.
Examples of return on assets
Wells Fargo
Net income = $21,938
Assets 2015 = $1,787,632
Assets 2016 = $1,930,115
Let’s plug the numbers into the formula.
Return on assets = 21,938 / (1,787,632 + 1,930,115) / 2
Return on assets = 21,938 / 1,858,874
Return on assets = 1.18%
That is pretty good; anything above 1% in the banking industry is doing great. This is one of the reasons why Wells Fargo has been able to withstand the scandal that has surrounded it lately.
Its ability to turn its assets into more assets continues to drive its businesses.
Let’s try another one, shall we?
Net income = $24,733
Assets 2015 = 2,351,698
Assets 2015 = 2,490,972
Return on assets = 24,733 / (2,351,698 + 2,490,972) /2
Return on assets = 24,733 / 2,421,335
Return on assets = 1.02%
Again, pretty darn good because we are looking for a number above 1%.
Let’s take a look at another bank; remember when we are doing these calculations it is best to look at comparing them across companies in the same industry.
It will give you the best comparison and relation to how the numbers play out.
US Bancorp
Net income = $5,944
Assets 2015 = $421,853
Assets 2016 = $445,964
Return on assets = 5944 / (421,853 + 445,964) / 2
Return on assets = 5944 / 433,909
Return on assets = 1.36%
Wow, what a big number. That is simply awesome in today’s banking world. So far US Bancorp is the best-performing bank in creating more assets for its shareholders based on this formula.
Let’s try one more. And for this one, we will go a little out of the circle of the banking world and use an investment bank.
Net income = $7,398
Assets 2015 = $861,395
Assets 2016 = $860,165
Return on assets = 7,398 / (861,395 + 860,165) /2
Return on assets = 7,398 / 860,780
Return on Assets = 0.86%
Well, for a look at the financials of a investment bank, it was pretty interesting. Notice how it words its documents? Earnings instead of net income was a neat twist.
Unfortunately, it looks like it has some work to do when it comes to improving its return on assets. The number that it put up was pretty poor – not horrible but not great. Depending on what else was going on with the company, it may bear passing on Goldman at this time.
Final thoughts
This was an interesting dive into the other fundamentals of the banking industry and how they drive profits for their businesses. Last week we looked at the efficiency ratio and how the banks divide up their income statements.
With that formula, you could see what was driving the income for the banks, whether it was interest income or loans or if it was on the fee side. That determined how efficient banks were with their income generation and whether they were good, responsible lenders.
That formula also could tell us how well a bank lent money, and if it choose good lenders and or if it was trying to drive profits for the sake of the profits – regardless of how risky the loans it approved were.
Return on equity told how us how management was able to generate profits from the shareholder’s equity. For every dollar it created, how many assets was it able to create for the shareholders.
With a return on assets, we can see how well a bank can turn its assets into other assets that create more shareholder’s equity.
With an incredibly easy formula to find all the data for, it gives you a great idea of how well the management creates more assets for the shareholders.
That is what it is all about, after all, creating more profit for the shareholders.
One thing that throws people off about this formula is when calculating it for a bank, the numbers will seem extremely low. You have to remember that banks are much more highly leveraged than an ordinary company, like a grocery story for example.
Because of this, they are going to run much lower return on assets percentages.
With banks, anything over 1% is considered outstanding and is what we strive for in our investments.
Again, this formula is just part of the process when valuing a bank, and we must never buy a company based on how much we like its results from this one formula.
Our goal is always to be able to find the intrinsic value of a company and then be able to buy with a margin of safety in case our calculations are incorrect – either because we made a mistake or we fell in love with the company and justify our numbers to fit that bias.
Next week we will look at the next calculation in our effort to value a bank. That will be a look into the book value per share formula.
As always, thank you for taking the time to read this post. I hope you found it of some benefit to you.
I would love to hear if you have any questions on return on assets or difficulties in calculating the formula.
Disclosure: ”‹The author is long Wells Fargo and has no plans to initiate any positions in the other stocks mentioned in the article.
