How to Assess a Bank Stock

Posted by admin on May 17, 2007 in Investment Products

There has been a lot of blogging activity recently about investing in bank stocks; a favourite industry of mine. With the recent flight to high performing dividend yield stocks, the stodgy and conservative industry has become quite popular to even the causal investor (dare I say that the pin-striped suited profession has become trendy?). The easiest way to buy a bank stock is to invest in a exchange traded fund which tracks the performance of a pool of banks. However, if you like active investing, and want to purchase one or two particular banks, this post deals with financial ratios I look for which are specific to the banking industry.

At the end of the day, a bank is, in its most simplistic form, a leverage play; it takes our money and lends it to other people with its profit being the difference between the interest it charges to others plus fees and the interest it pays to us. Given that a bank is playing with other people’s money, one of the key indicators of a bank is how it is managing its risk. After all, the downside is that it invests all our money poorly and still has to pay us interest on our deposits, resulting in an operating loss. The general rule is that the better a bank is at managing risk, the more profitable it should be. There are several ways to assess risk.

The first is the allocation of the loan portfolio. Banks, generally speaking, have several places they lend money such as retail, wholesale (to other banks, businesses or institutions), credit card and mortgages. Brokerage activities are generally financed with our money as well. A well-run bank will deploy its capital (really our money) among several business sectors; for example, the Bank of America has a reputation of very balanced loan portfolio. A poorly run bank will concentrate too much of its capital to one business sector and expose itself to risk. CIBC’s recent woes steaming from its Enron loans was due in part to the fact that it had a lot of exposure to wholesale banking and it was not managed well.

The second factor to look at is the “Tier 1 Capital Ratio” (common shares and qualifying preference shares/risk adjusted assets). It is not important to know how to determine Tier 1 Capital Ratio- most banks or research reports will summarize it for you. This ratio is regulated by law (in the U.S., the ratio must be no less than 4%). The general rule is that the greater the Tier 1 Capital Ratio, the more likely a bank is financially health since it is managing its risk properly and can handle any operating losses adequately. RBC has a Tier 1 Capital Ratio of 9.6% for fiscal year 2006; BMO has a Tier 1 Capital Ratio of 10.2% for the same period (so not including the recent trading losses) and Bank of America 8.64%.

The third factor to look at is “provisions for credit/loan loss” which is an expense a bank sets aside for bad loans. There tends to be a direct link between an increase in the provision for credit/loan loss and a drop in stock price. After all, a bank is basically telling the investing community that it has not managed our money well and it will not be able to collect on all its loans fully.

There are other indicators but I look for these numbers first since they reveal how the bank managing its risk. Given that banks are leverage plays, managing risk is an important factor in determining a bank’s value.

1 Comment on How to Assess a Bank Stock

By FinancialJungle.Com on May 17, 2007 at 4:38 pm

Very educational, Thicken. I have to read it one more time.

I like to throw in efficiency ratio. A lower efficiency ratio means the bank is keeping noninterest expenses very low.

Also is there a ratio that measures net revenues from interests versus fees? I suppose the banks with fee-based revenues are less interest rate sensitive. I read an old report that Canadian banks are deriving 50% of revenues from fees.