So you want to start analyzing bank stocks? Well you found the right place, for 2 reasons. #1 – it has all the metrics you need for bank stocks analysis, and #2 – It gives you a simple overview of how the credit cycle works, which is an integral part of understanding the industry.
First off, understand that bank stocks are a unique beast compared to every other stock out there.
If you take a glance at the financial statements of a bank, you’ll notice they’re different than most stocks because they carry a large number of liabilities on their balance sheet.
A balance sheet comprises of assets, liabilities, and equity, and the numbers of assets and liabilities tend to dwarf the equity. This renders (usually useful) metrics such as Debt to Equity (as measured by Total Liabilities divided by Shareholder’s Equity) mostly useless.
That’s why you’ll need special metrics if you want to truly understand bank stocks.
We’ll cover that, and then talk about the crucial role that the credit cycle plays on the entire banking industry as a whole, and how to consider that in your analysis of individual banks.
Simple Bank Stock Metrics
Some of these metrics are ones I found in co-host Dave Ahern’s fantastic post about evaluating the balance sheet of a bank, and I’d highly recommend reading that post too if you’re serious about analyzing bank stocks. Having worked in the industry, he’s very familiar with how banks operate and it definitely the expert between the two of us—I’m just here to dumb it down and make it simple.
Bank Business Model Metrics
First, let’s talk about metrics that are completely bank specific. These can be found in the financial statements, and help you determine the overall structure of a bank—whether they deal mostly with consumer deposits or more on the investment side, for example.
- Deposits to Liabilities = Deposits / Total Liabilities
Deposits can be found under Total Liabilities in the balance sheet, and this simple ratio can tell you to what extent the bank stock you are evaluating deals with vanilla consumer deposits.
- Loan percentage (%) = Loans / Total Assets
Loans can be found under Total Assets in the balance sheet, and like the first ratio above, should clue you in on the bank’s general structure. Where deposits can tell you how a bank brings in capital, the loan percentage ratio can tell you how the bank makes interest income (if a majority through standard loans, or not).
Bank Risk Metrics
Here’s two more metrics that go deeper into the consumer banking side of what can be analyzed from a bank’s financial statements. As was revealed in the 2008 financial crisis, the way banks loan out their capital isn’t always equal from a risk perspective. Some banks lend with less restrictions than others, so as an investor, it helps to know which banks operate in this way so that you are aware of the risks in buying their stocks.
- Loan to Deposit Ratio = Loans / Deposits
With fractional reserve banking (covered in this explanation about the Federal Reserve), banks aren’t required to hold all of the deposits they take in as cash. This is because it’s rare for a customer to withdraw all of his/her deposit at once, and especially rare for every consumer of the bank to do so.
With this type of banking, a bank can make loans on some (or even most) of its deposits, as long as it maintains a decent reserve for “just in case”. This ratio, essentially, tells you how aggressive or conservative a bank is with its policy for reserves.
Remember, loans can be found under Total Assets and deposits are under Total Liabilities.
- Bad Loan Percentage = Non-Performing Loans / Total Loans
This metric more specifically looks at the risk that was presented in 2008 and many other recessions, where borrowers aren’t able to make the interest payments on their loans and either go delinquent or default.
In a situation when loans eventually default, these loans that were on the balance sheet have little-to-no chance of being recovered and must be written down, causing charges to Net Income and a reduction to its balance sheet values.
Loans that fall into the category of missed payments that are delinquent or defaulted are designated as a Non-Performing Loan, and will be used in this metric.
Another term for Non-performing Loan in a bank’s financials is also Gross Charge-offs, and can be found in the section of the 10-k called Allowance for Credit Losses (for more help on how to read a company’s 10-k, visit this link).
Our trusty friend Dave says that a good Bad Loan Percentage is anything under 1%.
- Coverage of Bad Loans = Allowance for Non-Performing Loans / Non-performing Loans
You can think of this Coverage of Bad Loans ratio like a “buffer” for the bank, in the case that loans do go default. The larger the coverage ratio, the more cushion against future earnings and the balance sheet write downs that the company can have from an accounting standpoint.
That’s the key for this coverage ratio, and the Allowance for Non-Performing Loans particularly. It’s an accounting judgement more than anything, and doesn’t represent anything tangible. Instead it’s really just an adjustment to the balance sheet to simulate the negative effects of future write downs and give a better picture of the financial health of the bank today.
With this metric you’ll want to make sure that it’s not too high or too low, as it is upon management’s discretion. However, a reasonable ratio would be a 1 or better, meaning that they have more allowance for bad loans than actual bad loans (as of the time of the financial report).
An allowance does fall under Total Assets but is a negative number, which means too high an allowance would suppress the balance sheet and make it look worse, or could indicate a management that’s taking big risks with the loans they are writing.
Again, an examination of the bank’s 10-k and what kind of loans they are writing is also a recommended part of a bank stock analysis, and should supplement the simple ratios presented here.
Bank Stock Profitability Metrics
There are standard profitability metrics used in the finance stocks, and I wouldn’t go in-depth with them here, but will link fantastic articles about them which are widely used on bank stocks:
Another article also by Dave goes into a complete guide on profitability metrics, which you can use for a variety of stock analyses.
- NIM (Net Interest Margin) = Net Interest Income / Total Assets
NIM is the metric for the typical bank that reveals its most bread and butter profit source—how much they earn in interest from their loans after taking out interest paid for deposits.
All other things equal, a bank who can earn a higher “spread” on their interest paid and received will be the most profitable. Of course, in the real world, higher interest income usually means taking higher risks (read: loans more likely to default), so a high NIM isn’t always a panacea.
However, a NIM is extremely useful in evaluating a bank’s profitability and should be considered, especially if the 1st two business model metrics from this post reveal a bank stock that is mostly structured as a traditional consumer deposit bank.
Note: Astute investors should substitute Total Assets with interest-bearing assets only (such as loans and investments) to get the most accurate picture.
In theory, a larger cash position shouldn’t penalize a bank and indicate lower underwriting efficiency, though that’s exactly what happens to an NIM if using Total Assets (higher cash lowers NIM).
According to Investopedia, the average NIM for banks in the United States was 3.3% in 2018.
Keep in mind, interest rates have a bearing on how much interest a bank can charge on its loans, and so the NIM also isn’t a panacea because it can vary depending on the year and interest rate environment.
Instead, like all bank stock ratios, the NIM should be analyzed compared to competitors and compared to similar time periods, as the single nominal value doesn’t always tell the entire picture (for a variety of reasons and not just because of this).
Understanding How the Credit Cycle Impacts the Banking Industry
I’d say that I’m far from being a banking expert, but am blessed to stumble upon investors which much more experience and knowledge than I have.
One of those is billionaire George Soros, who wrote a fantastic classic called The Alchemy of Finance, where he lays out the history of one of the greatest banking booms in recent times, directly following the first oil shock of 1973.
A lesson like this also dovetails nicely with a simple macroeconomics lesson, and that is:
Credit moves in cycles, as explained brilliantly by another billionaire Ray Dalio, in his fantastic 30-minute Introduction to the Economic Machine.
Think of it this way.
- An everyday Joe wants to save some of his paycheck for a rainy day. He puts some of it into his bank as a deposit.
- The bank gathers a lot of deposits and sits on a pile of cash. They need to make money on this cash, so they loan it out.
- Those loans = credit.
- To complete this story, we’ll say that the bank takes Joe’s deposit and loans it to Jerry so that he can open a restaurant.
- Thus, the credit economic cycle is born.
This credit transaction creates $2 in assets from a single $1—Joe has $1 in his checking account, and the bank has $1 in a loan balance that’s owed back to them. This is key.
Note that there’s $2 in balancing liabilities that are also created: one appears on the bank’s balance sheet (they technically owe the deposit back someday) and one is owed by Jerry for his business loan.
Now, as the economy purrs along, the credit cycle expands.
Borrowers like Jerry create jobs –> leading to more money for workers like Joe –> leading to more deposits and more money for banks to loan out –> leading to more borrowers like Jerry to create more jobs…
And you get the beautiful economic growth that is made possible with credit.
The problem with credit is that just as it can spiral up into prosperity, it can also spiral down into a deflationary death spiral, because of its similar chain reaction nature.
Here’s the key on that:
- When credit becomes too overextended, crisis can happen
Say that the economy slows for whatever reason. It’s the borrowers and banks who have overextended on credit that will risk great economic despair, and this cycles throughout the credit picture too.
A slowing economy –> less job creation –> less spending –> over-extended businesses can’t pay back their loans –> banks take major losses and are less likely to make loans –> less job creation…
And the beautiful credit expansion turns into a contraction that can cripple an economy and send it into a deep depression.
So what does this all mean for your analysis on bank stocks?
Well, because banks are the central piece of the credit cycle, their stock prices are very much affected by the credit cycle.
As an investor, you need to understand that you can’t control the credit cycle, and that the boom and bust feature of it is inevitable.
I wouldn’t advise trying to time the credit cycle to buy in-and-out of bank stocks (as covered on the blog in great detail by this post about Long Term vs. Short Term Investing).
Just understand that the most risky bank stocks (as measured by the metrics covered above) are the ones to hurt shareholders the most in a crisis, AND that most conservative bank stocks as analyzed by solvency ratios should survive a crisis and see a long term rebound in share price after one.
I’ve provided a lot of useful links throughout this guide and I hope you’ll find them helpful.
If I had to pick one recommended resource to take your analysis of bank stocks to the next step, I’d really like to double down on the importance of reading and understanding 10-k’s.
It could go without saying for all stocks analysis, but especially for a bank—where the metrics are so much different from every other business—you really need to know the intricacies of the business, because this bank isn’t the same as that bank even though they both have the word bank in them.
And seriously, be diligent about the research and your reading.
After all, like Uncle Warren (Buffett) once famously said “only when the tide goes out do you discover who’s been swimming naked”, and that’s ever so true with banks as well.