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Stepan Lavrouk
Stepan Lavrouk
Articles (74) 

How to Value Banks

Four key metrics to use when valuing financials

January 31, 2019 | About:

In a previous piece, we discussed why 2019 may be a poor year for financial stocks. The future of interest rate hikes looks uncertain, the Trump administration’s tax reform seems to have run out of steam, and with the Democrats in control of the House, the specter of increased regulation is looming on the horizon.

But how does one go about projecting the success or failure of any given bank? Some people may use universal metrics, like price-earnings or price-book. These certainly have their uses in valuing the financial sector. But, as with most industries, there also exists a set of specialized tools that investors should use specifically to evaluate financials.

Return on assets (ROA)

As you may know, return on assets is calculated by simply dividing net income by the total assets of a company. As such, it is a measure of how efficiently a company is using its assets to generate income. It is a useful measure for valuing any businesses, but it is particularly applicable to banks, because the income earned by banks is so tightly correlated with their balance sheets.

ROA enables you to compare similar companies to one another. So if two banks each have $100 million in loans on their balance sheets, but Bank A has an ROA of 1% and Bank B has an ROA of 0.5%, then that is a pretty strong indication that Bank A is using its capital in more efficient and clever ways -- perhaps it has a lower delinquency rate, or manages to charge higher interest on its loans.

Net interest margin (NIN)

Net interest margin is the difference between a bank’s interest income and the income that it pays out to borrowers, usually expressed as a percentage. The higher it is, the more money the bank is making relative to the amount of money that it is paying out. As we explored previously, rising interest rates usually (but not always!) correlate to higher net interest margins, as banks earn more money on the short-term fixed income investments they make relative to the money they pay out to existing customers, which stays the same.

Loan-to-deposit ratio (LDR)

As the name suggests, this is the relationship between how much money a bank has lent out to how much it has on its books. A ratio of less than 1 means that a bank is lending out less money than it has. A ratio of more than 1 means that a bank is lending out more money than it has. It is both a measure of a bank’s efficiency (if it is too low, then the bank is not using deposits effectively) and of its liquidity (if it is too high, then the bank will not be able to survive a run, that is, a scenario in which customers want to withdraw their money all at once). As a rule of thumb, the ideal loan-to-deposit ratio for U.S. financials is considered to be between 0.8 and 0.9.

Non-performing loan ratio (NPLR)

A non-performing loan (NPL) is a loan that has been in default for more than 90 days. The NPLR is the ratio of "good" loans to NPLs. All banks will inevitably have bad loans, but the better a bank is, the fewer NPLs it has as a percentage of its overall assets. In countries with weak banking systems like Greece and Cyprus, the percentage of NPLs has been known to reach more than 20%! Clearly these are not scenarios in which an investor would want to find themselves, so most healthy financial sectors do not have ratios of more than 2-5%.

Summary

The success of a bank rests on two things: first, whether it is using its capital efficiently and second, how well-protected it is from shocks like runs and economic downturns. If you can identify a stock with a high return on assets and net interest margin, a good loan-to-deposit ratio and a low percentage of non-performing loans, then you will likely have found yourself a winner.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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