6 Metrics Bank Investors Must Know – Part 1

Editor’s note: A link to the second part of this series has been added near the end of this piece. It is given in italics.

Singapore’s banking trio of DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39), and United Overseas Bank Ltd (SGX: U11) are amongst the top 10 largest companies in the stock market here by market capitalisation.

Given their size, there are two observations I have. First, it’s likely that there are many bank investors out there. Second, investors will likely come across the banks in their investing lifetime. These make the ability to analyse bank stocks important.

Unfortunately, banks can be complicated creatures. But, that doesn’t mean we have to resign to being helpless when it comes to determining how good a bank stock is. There are some simple yet crucial metrics that can give us a head-start when it comes to making sense of banks.

I’d be talking about a total of six of these metrics that bank investors have to know. The first three metrics will be covered here with the next three appearing in a separate upcoming article.

1. Return on Equity

Mathematically, the Return on Equity looks like this:

Return on Equity = Net Income / Shareholder’s Equity

This metric measures a bank’s ability to generate profits with shareholders’ capital. In general, the higher the better, although investors have to be aware that a return on equity that’s too high may be a sign that a bank’s taking on too much financial risk. That’s because leverage (the use of borrowings) can help juice up a firm’s return on equity.

DBS, OCBC, UOB return on equity

Source: S&P Capital IQ

Over the past five years since 2010, you can see that OCBC has been the best local bank in terms of generating returns for shareholders. DBS has had the worst track record; investors may want to watch for signs of the bank slipping into mediocrity again in the future.

Investors may also want to note that a bank’s return on equity has a notable effect on its price-to-book ratio (PB), the quintessential valuation number for a bank. Generally speaking, the higher a bank’s return on equity is, the more investors are willing to pay per dollar of book value, thus leading to a high PB ratio.

The table above also shows us that the three banks’ returns on equity have been declining since 2012 and that can affect their future valuations if the trend persists.

2. Return on Assets

The formula for this ratio is given as:

Return on Assets = Net Income / Total Assets

It’s a close cousin of the Return on Equity, but what it does is to give investors a sense of how much profit a bank can generate per dollar of asset employed in the business. Like with the Return on Equity, generally speaking, the higher the Return on Assets is, the stronger a bank is.

DBS, OCBC, UOB return on assets

Source: S&P Capital IQ

As the table above shows, UOB has been the most adept at sweating its assets over the period from 2010 to 2014.

3. Efficiency Ratio

The efficiency ratio is given by the following equation:

Efficiency ratio = Noninterest Expenses / Net Revenue

In essence, the metric measures how good a bank is in managing its expenses (the lower the ratio, the better). While expense-management might seem trivial – every company has to aim toward proper management of expenses – it can be particularly important in banking.

Warren Buffett had laid out how an insurance company can out-compete its peers in his 1987 Berkshire Hathaway annual shareholder’s letter (emphasis mine):

“The insurance industry is cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way. In such a commodity-like business, only a very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels.”

There are some differences between the banking industry in Singapore and the insurance industry Buffett describes. But a key characteristic – undifferentiated products – makes Buffett’s observation highly applicable.

Beyond this, poor control of expenses can also lead to excessive risk-taking by a bank – and that’s something investors wouldn’t want to see. This is how Columbia Business School professor Charles Calomiris describes the idea in his book, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit (emphasis mine):

“Given an environment in which risk-taking with borrowed money was considered normal, it is easy to understand why some bankers, particularly those who were having trouble competing against more efficient rivals, decided that the right strategy was to throw caution to the wind.”

So, how has the local banking trio of DBS, OCBC, and UOB performed in this aspect?

DBS, OCBC, UOB efficiency ratio

Source: S&P Capital IQ

As the table shows, the three banks have had really low efficiency ratios over the past few years and that’s a great thing to note. Investors may want to watch for signs of deterioration in the efficiency ratio as that may herald higher levels of risk-taking by the banks.

A Fool’s take

As noted earlier, banks are notoriously tougher companies to analyse as compared to say, a simple manufacturing firm. I hope what I’ve covered here can help you give you a leg-up when you’re looking at banks.

For the next three important metrics – hit this link.

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 owns shares in Berkshire Hathaway.