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Chandan Dubey
Chandan Dubey
Articles (150) 

Valuing a Bank Made Simple: The Balance Sheet

March 21, 2012 | About:

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.

Securities/Trading assets

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.

Shareholder equity

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.

About the author:

Chandan Dubey
I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

Rating: 4.4/5 (44 votes)



JeanPierreSarti - 6 years ago    Report SPAM
For those interested more info about STD by another Gurufocus contributor:


Cogito - 6 years ago    Report SPAM
I'd be very careful when trying to deduce a bank's value as you would do for other businesses. Frankly, I believe that a bank's balance sheet doesn't help you at all in estimating its value.

Why? Well, a bank's balance sheet tells you hardly anything about the risks the bank is exposed to. Banks are highly leveraged, hence when risks strike, they may kill them. The subprime crisis has shown that banks themselves were not able to understand their risks - so how could you as an outsider? BTW: a nice description of this can be found in the book "The big short" by Michael Lewis. It's a great read and it teaches a lot about the banking business.

Basel III and other upcoming regulation may help to make banking somewhat safer by introducing countercyclical buffers, increased tier 1 and tier 2 capital requirements, leverage rations, liquidity ratios, and so on. However, I believe that even with all this regulation, banks will continue to run risks that can kill them - the incentives to do so are simply too high. Besides, the new regulation will reduce banks' margins drastically and change the business.

Finally: yes, it is likely that several banks are undervalued at the moment. However, I believe that you cannot value a bank as you would value other businesses, so you cannot know whether the bank is indeed undervalued and whether its risks are priced in. It's fine to buy stocks from the banking sector, but in my opinion this is speculating, not investing.
Chuck Carnevale
Chuck Carnevale - 6 years ago    Report SPAM

Thanks for a concise and well written overview of banking.


Kayefam - 6 years ago    Report SPAM
I really enjoy the way Chandan simplifies investing and breaks it down step by step since I am a relative novice compared to many gurufocus members. I hope she will write more articles.
Cdubey - 6 years ago    Report SPAM
@Kayefam The picture does not look manly to you ? I am a guy ! :)

@Chuck: Thanks. I really enjoy your writings. I am happy that you read my article.

@Cogito: Agree with you. Highly speculative industry. It is surprising to see that no company concisely writes as to how they make money. They do not describe their business models in short either. This should be made mandatory that every company describes their business model in simple words. The investment banking part of the banking industry is the one which gives me a lot of trouble. This is why I sold CS.

I expect to write a bit more on the management of a bank and how to value them depending on the ratios. Then I plan to look at the loans and their composition for STD and LYG. Let us see how far I go.
Ramands123 - 6 years ago    Report SPAM
Good artical. Although I think u missed debt issue in public markets under borrowings.

I have tough time with understanding details of investment banking as well.
Cornelius Chan
Cornelius Chan - 6 years ago    Report SPAM
I agree with Chuck C on this one: a nice and simple bank writeup. If you ask my opinion, 9.5 out of 10 of the article-writers here on GF are too afraid to write an article on banking. It is manly of you!

p.s. Kayefam: speaking of manly, take another look at Cdub's picture -- hello!

That's he not she buddy!
Benethridge - 6 years ago    Report SPAM
Very clear explanation. Thanks for posting it.

SushiBlade - 6 years ago    Report SPAM
I admire your courage in choosing to do a write-up on banks. They are clearly a 'different animal' when it comes to trying to pinpoint where there is value or determining whether an institution is undervalued or not.

In terms of comparing two banks to determine a value discrepancy, a good place to start would be choosing two banks within the same category and approximate asset grouping.

The banks you compare have different orientations. WFC is a top-tier US bank that should be compared to a USB, another Buffet holding, I believe. I haven't followed either for quite some time but I know they both have similar histories as acquirors of other banks. STD has more of a international orientation of which the US is only a segment.

Only within the past few years has the characteristics of WFC's acquisitions changed, due primarily to the 2008 financial crisis but it is still basically a domestic bank. You have to look at the management decisions made at these institutions and how they were able to help them reposition themselves over the past few years.

The quantitative aspects of the banks are the result of the qualitative factors, of which the management at these institutions is number 1. I tend to think that weighs heavily in Buffet's choices when it comes to financial stocks.

Your approach to analyzing banks is very straight forward and well thought out as mentioned earlier but banks are complex creatures!

Is there any wonder why more Wall Street firms don't provide coverage of the industry beyond the top 20 banking firms?

In any event, I look forward to reading more of your analyses.
Carmine Romano
Carmine Romano - 6 years ago    Report SPAM
Look are the bank's available liquidity and the quality of its Tier One Assets, as adjustments were made to allow more volatile assets qualify as Tier One Capital.
TKORL - 6 years ago    Report SPAM
@ Cogito

I definitely see your point, but what other way would you analyze a bank if not by looking at its balance sheet? Perhaps I have misinterpreted your comments.
John G. Alexander
John G. Alexander - 6 years ago    Report SPAM
Overall, an excellent primer for looking at bank stocks. Good work!

Key issue in valuing the financial health of a bank is determining whether or not it is properly taking reserves for loan losses (which hit the income statement/reported EPS, hence management reluctant to do so if avoidable). With Basal III coming, the hit to equity account is also a critical issue.

In order to do this, one MUST go to the FR Y-9C in order to review the status of the loans on the balance sheet and compare that to how much management is reserving for losses. The temptation in good years is to "over-reserve" so they have money for a weak quarter (if the company is on track to beat Wall St. consensus estimates by $0.10, taking ($0.05) for loan losses won't hurt them as they'll still handily surpass consensus estimates).

The process I used and the source for the FR Y-9C is found in my article on Bank of America:


This is the only way to improve your odds of making an educated bet that you understand the financial health of a bank stock. I'm always blown away by the number of "professional" investors who put client money in bank stocks and when I ask them if they thought management was managing EPS by playing with loan loss reserves or whether the reserves were adequate, I get a puzzled look followed by the question, "What's a FR Y-9C?"

Professional investor or not, if you're investing in bank stocks, do yourself a favor and learn about and scrutinize the Y-9C before investing in any bank stock. Doing otherwise is simply gambling, not investing.

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