There are three bank stocks in Singapore’s stock market, namely, DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39), and United Overseas Bank Ltd (SGX: O39). On the surface, they appear roughly similar – all three are, after all, home-grown banks and as the saying goes: A bank, is a bank, is a bank. But for investors who are interested in bank stocks for long-term investing in 2016 and beyond, it may pay to dig beneath the surface to look at each bank’s fundamental strengths. There are many financial metrics that can tell us how strong a…
On the surface, they appear roughly similar – all three are, after all, home-grown banks and as the saying goes: A bank, is a bank, is a bank. But for investors who are interested in bank stocks for long-term investing in 2016 and beyond, it may pay to dig beneath the surface to look at each bank’s fundamental strengths.
There are many financial metrics that can tell us how strong a bank’s business is, but let’s just focus on four: The asset-to-equity ratio; the loan-to-deposit-ratio, the efficiency ratio, and the growth in book value per share.
Banks are leveraged entities – that is to say, they depend on borrowed money to run their businesses. And when leverage is the name of the game, risk is added to the equation for investors. That’s why it is important for investors to always keep an eye on a bank’s balance sheet.
There are many different ways that investors can measure the “riskiness” of a bank’s balance sheet. A simple but effective method is to find its asset-to-equity ratio. Mathematically, we simply divide a bank’s assets by its equity and in doing so, we can know how much a bank is borrowing for each dollar of shareholder’s capital that it has.
If a bank has S$100 million in assets but just S$1 million in equity, it will have an asset-to-equity ratio of 100. In this scenario, even a tiny 1% decline in the value of the bank’s assets will cause its equity to be completely wiped out, which is clearly not a good thing for the bank’s investors.
By the same token, a bank with S$100 million in assets and S$20 million in equity will have a leverage ratio of just 5. In this case, its equity will be cleared out only if its assets fall by 20% in value. Going with this train of logic, the lower the asset-to-equity ratio, the less risk there is likely to be for investors, all others being equal.
Here’s how the asset-to-equity ratios for DBS, OCBC, and UOB have changed over the past five years:
We can see that UOB comes out tops here, as it has had a lower asset-to-equity ratio as of the third-quarter of 2015.
With banks, there are risks associated with leverage and we’ve just dealt with that. There are also risks that involve liquidity, which also stem from the basic business model of banking, and that is to borrow money (mainly by taking in deposits) and lending the capital out.
Here’s how professors Charles Calomiris and Stephen Haber, from the Columbia Business School and Stanford University, respectively, describe liquidity risks in their book Fragile By Design:
“[It] is extraordinarily difficult, if not impossible, for bankers to exactly match the durations of their contracts with depositors and debtors. Bank deposits can typically be withdrawn on very short notice, but the loans financed by those deposits may extend for months, years, or even decades.
In fact, bankers face the risk that, even if their banks are not insolvent, worried depositors might show up en masse to withdraw their money, and there might not be enough cash in the till to satisfy all those withdrawal demands.”
To estimate the amount of liquidity a bank has, we can look at the loan-to-deposit ratio. Mathematically, it is given as such:
Loan-to-deposit ratio = Total loans / Total deposits
A higher loan-to-deposit ratio will mean a bank has a lower margin of safety in being able to meet large short-term demands for withdrawals or emergency cash-needs. We can observe how the loan-to-deposit ratios for Singapore’s banking trio have evolved since 2010:
UOB once again emerges at the top when it comes to the loan-to-deposit ratio – the bank has the lowest ratios for both the third-quarter of 2015 and the average from 2010 to 2014 when compared to DBS and OCBC.
This ratio is very important for banking investors because it can give some insight into the amount of risk that a bank is, quite literally, forced to take in order to generate a profit. The math involved for the efficiency ratio is given below and it measures a bank’s non-interest expenses as a percentage of its revenue.
Efficiency ratio = Non-interest expenses / Net Revenue
Generally speaking, investors should prefer a bank with a low efficiency ratio, as it means that the financial institution has tight cost controls and wouldn’t have to write riskier loans or engage in higher risk activities in order to make money.
To further illustrate how the efficiency ratio is linked to risk-taking, I’ll turn, again, to Calomiris and Haber’s book, Fragile By Design:
“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 [emphases mine].”
You can observe how the efficiency ratios of DBS, OCBC, and UOB have changed over the past few years in the table below:
As the table shows, OCBC has the best efficiency ratios amongst its banking peers.
Growth in book value per share
As the bulk of a bank’s assets are financial assets, changes to its book value per share are a good rule of thumb in assessing how its real economic worth has grown or shrunk over time. To reach the book value per share, here’s the math:
Book value per share = (Total assets – Total liabilities – Minority Interest) / Number of shares outstanding
A bank that is able to grow its book value per share would indicate that it is creating value for shareholders. But, caution is warranted for banks with abnormally high growth rates – that’s because banks can juice their growth by taking on more risks, which exposes shareholders to potentially grave losses.
The table above shows how DBS, OCBC, and UOB’s book values per share have grown since 2010. And as you can see, UOB has displayed the fastest historical growth in book value per share amongst Singapore’s banks.
A Fool’s take
In a final tally, UOB emerges as the clear winner as it has bested DBS and OCBC in three of the four categories we have studied. While what we’ve seen are important and insightful, they should be used only as a starting point for further research and shouldn’t be taken to be the final word on the investing merits of the three banks.
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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 company mentioned.