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An Investor’s Quick Checklist for Banks – Part 2

Singapore is home to some of the biggest banks in South East Asia and these banks have a big influence on the stock market here.

Given this backdrop, it can be meaningful for investors to not only know some of the important risks that banks face, it can also be worthwhile to know the important metrics to look at when analysing banks.

There are four banks listed in Singapore: DBS Group (SGX: D05), Oversea-Chinese Banking Corporation (SGX: O39), United Overseas Bank (SGX: U11) and Hong Leong Finance (SGX: S41). By comparing the four, we can get a sense of the quality of each bank.

Strong balance sheet

First and foremost, a bank with a strong balance sheet will be more able to withstand financial shocks. One direct method of gauging the strength of a bank’s balance sheet is through the leverage ratio, which is calculated simply by dividing a bank’s total assets over its equity. With the leverage ratio, the lower the figure, the stronger a bank’s balance sheet is.

During the Global Financial Crisis, the most cavalier American banks were levered up to 30 to 50 times. When leverage’s used so wantonly, it only requires losses of 2% to 3% in the bank’s assets to completely wipeout shareholders’ equity.

In Singapore, banks having a leverage ratio of around 10 to 15 times are still generally considered healthy.

Return on equity (ROE) and Return on assets (ROA)

The ROE and ROA metrics are a good measure of the efficiency of a bank in earning profits.

When reviewing the ROE and ROA of a bank, we should not only take note of banks that are showcasing extremely low ROEs, we should also be wary of banks that manage to achieve extremely high ROEs. The latter situation can be a cause of concern because a high ROE might be due to a rapid expansion of a bank’s business that occurs in the absence of control of lending standards or an under-provision for non-performing loans.

In the  current environment, a bank earning an ROA of more than 1% can be viewed as a high quality bank.

An appropriate measure of value

The most commonly-used valuation metric for banks is the price to book (P/B) ratio.

Since most of the assets of a bank are mostly financial assets that are generally quite liquid, their real economic value at any point in time can be quite close to what’s stated on the balance sheet. Therefore, using the P/B ratio to compare banks tend to be quite useful.

However, if we come across a bank that is trading at a much lower P/B ratio than its peers (i.e. it’s much cheaper compared to other banks), there is normally a good reason for it. The P/B ratio should always act as the starting point of our analysis, not the ending.

Foolish Bottom Line

If we do a quick scan across the four banks in Singapore, we can see that Hong Leong Finance is trading at around 0.7 times its book value while the big three banks has P/B ratios ranging from 1.1 to 1.4. Looking at these valuation figures, here’s an interesting question for you to ponder: Is Hong Leong Finance a bargain or a value trap?

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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 contributor Stanley Lim doesn’t own shares in any companies mentioned.