How to Analyze a Bank’s Profitability

Singapore’s three largest banks have been on a whirlwind of a run this year. They have been the major driving force behind the Straits Times Index (SGX: ^STI) 12% year to date return thus far.

In light of this, I have decided to write a three-part series on analyzing a bank stock. The first part, which focuses on assessing a bank’s balance sheet, can be found here.

This is part two of the three-part series and I will be looking at how to analyze a bank’s profitability and if it is sustainable.

Just like assessing the balance sheet of a bank, we can measure a bank’s profitability by using five simple metrics.

Net Interest Margin

One of the first things you may notice on a bank’s income statement is that the revenue earned is divided into two components, namely, interest income and non-interest income. As mentioned in the first article, a bank’s business comprises of traditional loan interest revenue and other fee-orientated services.

When we assess the loan performance of a bank, we need to see how profitable the bank’s investments are. To do this, we take the difference between interest income and interest expense. We then divide this by the total value of loans and securities. This gives the net interest margin as shown below:

Net Interest Margin= (Interest income – Interest Expense)/ Total value of Loans and Securities

Typically, a Net Interest Margin of between 3% and 4% is healthy and sustainable. This means that the bank is able to earn a good margin on the money it loans out and has a buffer to work with even if there is a drop in interest rate levels.

Efficiency Ratio and Return on Equity

The Efficiency Ratio and Return on Equity metrics measure how well the bank is able to utilize its assets.

The efficiency ratio as the name suggests, measures how cost efficient a bank is. To calculate the efficiency ratio, we divide non-interest expense with revenue. This is a better tool to use than profit margin as it removes the short-term volatility of interest rates fluctuations out of the equation.

This is also closely tied to return on equity or ROE. The ROE of a company looks at how efficient a company is using its assets to generate a profit. If a bank has a ROE that is consistently above 10%, it is usually a good sign as it shows that management is able to generate solid returns on its assets.

Non-Performing Loans and Non-Performing Allowance Ratio

One of the biggest threats to a bank’s profitability is loan default. Therefore, it is important to measure a bank’s exposure to risk and whether it has priced this in to its financial statements.

Non-performing loans (NPL) are loans that have lagged behind on payment. If NPLs make up a large percentage of total outstanding loans, banks profits will obviously take a large hit.

Typically, NPL percentage should be low. We can also get a good idea of a bank’s performance in this regard by comparing it with other banks in the region.

Because banks know that not all its loans will be paid back, they usually take this into account on their financial statements by giving allowance for default. The non-performing allowance should be at least 100% of NPLs to ensure that investors do not get a rude awakening if things go awry.

The Foolish Bottom Line

Bank stocks in Singapore have been on a roll in recent months. There are a mulitutude of factors that could have caused this. Tailwinds include the proposal of the ASEAN (Association of Southeast Asian Nations) Economic Community, which will see Singapore well positioned to become the financial hub of the region. Other factors like possible interest rate hikes and the proliferation of the Fintech industry are also contributing to the optimism surrounding banks in Singapore.

With that in mind, investors who are looking at banks as an investment can make use of these five simple metrics to measure the profitability of a bank and to see how sustainable they are. The next article of the series will look at how to value a bank stock.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.