So you want to start analyzing bank stocks? Well you found the right place. 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. For a bank, there is a much larger 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.
In this post, we’ll cover the following [Click to Skip Ahead]:
Some of these metrics are also found in our evaluating the balance sheet of a bank blog post.
Bank Business Model Metrics
First, let’s talk about metrics that are completely bank specific. These can be found in the financial statements and can help you determine the overall structure of a bank, like 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. This simple ratio can tell you to what extent the stock you are analyzing is like a traditional money center bank.
- 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 much of those deposits the bank has loaned out.
Bank Risk Metrics
Here are 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, depending on size or credit risk.
- 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 customer 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 default risk. Non-performing loans come from borrowers who aren’t able to make the interest payments on their loans. These loans either go delinquent or default.
If these loans do default, the money that has been lent out has little-to-no chance of being recovered and must be written down. The write-downs create charges against Net Income and a reduction to balance sheet values.
Loans that fall into the category of missed payments that are delinquent or defaulted are designated as a Non-Performing Loan.
Another related metric in a bank’s financials is “Gross Charge-offs”, and can be found in the Allowance for Credit Losses sections of the 10-k.
Generally, 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 default. The larger the coverage ratio, the more cushion against future losses that the company has (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. Its goal is to give investors 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.
An allowance is recorded in the balance sheet under Total Assets, but is a negative number.
Bank Stock Profitability Metrics
Standard profitability metrics for stocks are also used on banks, such as (click to read more):
We have another article that 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 which reveals its most bread-and-butter profits source. It measures how much the bank earns 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 higher risk loans– so you have to be careful.
However, NIM is extremely useful in evaluating a bank’s profitability, especially the more income one produces from loans from deposits.
According to Investopedia, the average NIM for banks in the United States was 3.3% in 2018.
Keep in mind, interest rates are variable and move from year-to-year. This can change the average NIM for all banks at any given time.
Like all bank stock ratios, the NIM should be analyzed compared to competitors and compared to similar time periods. It should not be used entirely on its own with no context.
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 single recommended resource, I’d say learn the skill 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.