Two Important Ratios for Understanding Banks

The Straits Times Index (SGX: ^STI) in Singapore is comprised of 30 different companies in some very different industries: from palm oil to the financial markets; aviation to casinos; and oil rigs to newspapers.

Yet, it wouldn’t be a stretch to say that the banking industry dominates Singapore’s stock market barometer. The three local banks, DBS Group Holdings (SGX: D05), Oversea-Chinese Banking Corporation (SGX: O39), and United Overseas Bank (SGX: U11), collectively accounts for more than 30% of the index’s overall movement.

Bank Weighting in Index (as of 8 Jan 2013)
DBS 11.33%
OCBC 9.93%
UOB 9.28%
Total 30.54%

Source: Data for SPDR STI ETF

By virtue of that fact, it’s perhaps worthwhile for investors to gain a better understanding of the banks from an investing-perspective. We’ve previously gone through the importance of four different banking-metrics (see here and here): Price to Tangible Book Value; Return on Asset; Net Interest Margin; and Asset Quality.

Let’s dig into two more today: Efficiency, and Return on Equity

1. Efficiency

One of America’s best banks over the past decade, Bank of the Ozarks, delivered shareholder returns of more than 400% in the 10 years ended Dec 2003. The bank did it through a focus on, among other things, efficiency.

In banking terms, efficiency measures the percentage of revenue that goes to non-interest costs and as my American colleague Matt Koppenheffer says, “Cost discipline [among banks] may not be sexy, but it’s a proven winner time and again.”

Here’s how DBS, OCBC, and UOB’s efficiency looks like over the years

Efficiency* 2012 2011 2010 2009 2008
DBS 44.8% 43.3% 41.4% 39.4% 43.3%
OCBC 40.6% 43.2% 42.3% 37.3% 43.7%
UOB 42.3% 43.0% 41.0% 38.4% 39.0%
*With the efficiency ratio, the lower the better

Source: S&P Capital IQ

From the table above, we can see that over the past five years, the local banking trio has managed to keep a tight rein on costs, even managing to best well-run giant US banks like Wells Fargo, whose efficiency ratio averaged 57.6% in the same period.

2. Return on Equity (ROE)

ROE – the measure of the profits made on shareholder’s funds – is an important metric for most companies, and that includes banks. The metric is also closely linked to a bank’s return on assets, with the difference being that ROE incorporates the bank’s returns on borrowed funds.

Generally speaking, ROEs that are in the single-digits are considered pedestrian and usually point toward management that could be performing better

ROE LTM* 2012 2011 2010 2009 2008
DBS 11.5% 11.6% 9.9% 5.9% 8.3% 9.1%
OCBC 10.6% 15.8% 10.1% 10.8% 10.7% 10.5%
UOB 11.8% 11.7% 10.5% 13.3% 11.0% 11.7%
*LTM = Last 12 months

Source: S&P Capital IQ

From the ROE table, we can observe how DBS has been, among the trio, the least effective bank at generating returns from its shareholders’ funds. That might go some way in explaining why DBS’ shares have had the lowest total returns since the start of 2008.

Bank 2 Jan 2008* 8 Jan 2013 % Change
DBS S$14.03 S$17.37 24%
OCBC S$6.72 S$9.76 45%
UOB S$16.05 S$21.10 31%
*Prices on 2 Jan 2008 are adjusted for dividends, stock splits, rights offerings, and spin-offs

Source: S&P Capital IQ

Foolish Bottom Line

So there you have it, two important ratios – efficiency, and return on equity – to help you better understand banks. But, that’s definitely not the end of it.

Banks are also very complex entities, and my colleague David Kuo has even called them (rightfully so, in my opinion) “mysterious black boxes”.

For that reason, much deeper analysis would be required before any informed investing decision about banks can be made. The other banking-metrics I mentioned earlier would be useful, as is a study of a bank’s management, shareholder-friendliness, and growth opportunities etc.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.