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4 Important Bank Metrics

July 17, 2023
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Investing banks entail looking at other types of metrics that you will normally not consider when investigating companies in other industries. 

Why is that? Well, for one thing, banks are in regulated industry and banks have a different capital structure. Banks effectively take money from deposit holders and lend money out at a higher rate. It's not like a typical company where you have shareholders and debtholders.

Below, I talk about 4 metrics that are important to look at when investigating bank stocks.

1. Return on Assets

According to Buffett, this is the most important metric to assess when looking at a bank.

https://www.fool.com/investing/general/2013/04/08/buffetts-key-to-valuing-banks.aspx

Return on assets shows how much profit a bank produces relative to the assets it owns.

In general, you want ROA to be at least above 1% and hopefully above 2%. Buffett invested in such a bank in 1969 i.e., Illinois National Bank & Trust Company.

2. Return on Equity

Return on Equity is closely related to ROA. Roughly speaking, when you divide ROE by ROA it gives you an indication of the bank's leverage e.g. ROE 10% and ROA 1% then leverage is 10x. 

In general, you don't want leverage to exceed 10x. Because we usually value banks from a shareholder perspective we want ROE to exceed the cost of equity, so ROE of 10% and above is preferable.

3. Tangible Book Value

Tangible book value is the difference between tangible assets and liabilities. It is the amount shareholders can expect to receive in the case of a company liquidation event.

For banks, we would like tangible book value to be close to market value. So, Market Cap / Tangible Book Value ~ 1. Banks with higher profitability metrics will generally trade above tangible book value.

4. Efficiency Ratio

Because banks are mainly seen as a commodity type business, most of them offer nearly identical products, we want a bank with a good cost structure. If they can't really compete in terms of their product offerings then having a low cost structure is a competitive advantage.

We can compare banks by looking at their efficiency ratio. The efficiency ratio is calculated by dividing the bank's operating expenses by total income. It is like a cost to income ratio. In general, a efficiency ratio of 60% and below is preferable.

To sum up, the ideal bank is a bank that earns good money on its existing assets without the use of excess leverage, is fairly cheap, and has good cost structures in place.


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