Investing in bank stocks can be a good long-term financial investment, as banks serve an important societal need and are heavily regulated. However, owing to the unique nature of banks as an institution, investing in bank stocks also comes with its own risks, modes of analysis and unique dynamics to take into account when making trading decisions. Here are some metrics to consider when evaluating which banks you want to invest in.
Why invest in bank stocks?
One of the biggest benefits of investing in bank stocks is the industry’s heavy regulation, owing to the essential public service they provide and the potentially catastrophic effects of financial crises. This regulation means banks are required to maintain minimum capital levels, with larger institutions also having to undergo “stress testing” to determine their ability to survive in adverse economic environments. As a result, investing in bank stocks has relatively lower risk compared to other industries, although this regulation does not protect banks from risk entirely- banks as an industry are vulnerable to recessions and falling interest rates among other things.
The banking industry’s unique characteristics also offer it unique benefits that make it a relatively solid investment if you know what you’re doing. Banks serve an essential societal function that means the industry will stand the test of time, and the nature of banks as a public service means banking business models are more accessible and understandable.
The banking sector can be a good choice for value investors, who operate by picking stocks that appear to be trading for less than their intrinsic or book value. This is due to the sector’s high leverage and the nature of banking as a business giving the industry a relative vulnerability to emotional short-term forces, which makes long-term investment in banks more appealing to value investors.
However, as mentioned above, the banking industry has unique downsides as well as unique upsides. These include the aforementioned vulnerability to recessions and falling interest rates, as well as the risk of disruption by sectors such as the financial technology (fintech) industry, which has risen in popularity recently and created additional pressures for banks.
Types of bank
Before investing in bank stocks, it’s important to consider what type of bank stocks you want to invest in. There are three main types of bank to keep in mind:
- Commercial banks
Commercial banks are what most people think of when they hear the word “bank.” These banks make their money through lending to customers and profiting from their interest margin.
- Investment banks
Investment banks are primarily focused on the creation of capital for various entities, including companies and governments. As part of these services, investment banks facilitate complex financial services for these entities, advise clients on mergers and acquisitions and manage wealth.
- Universal banks Universal banking is a system in which banks provide a wide variety of comprehensive financial services, combining the services of commercial banks and investment banks, providing all services as one entity.
Important metrics to consider
- Net interest margin (NIM) The net interest margin (NIM) measures the difference between the interest income generated by the bank on loans and the amount of interest paid out to lenders on savings accounts and deposits, relative to the amount of their Interest earning assets.
- Return on assets (ROA) The return on assets (ROA) indicates how well a bank uses its assets to generate income, and is calculated by dividing a bank’s net income by its total assets. The higher the ROA, the better the bank is at making money from its assets.
- Return on equity (ROE) The return on equity (ROE) is a measure of the profitability of a business in relation to the equity, and is calculated by dividing a bank’s net income by its total shareholder’s equity. The higher the ROE, the better the bank is at making profit from shareholder equity.
Important ratios to consider
- Capital ratio A bank’s capital ratio is calculated as its capital divided by the risk-weighted assets. Capital ratios are usually calculated for different types of capital (e.g. tier 1 capital, tier 2 capital) and are used to assess a bank’s susceptibility to sudden and unexpected increases in bad loans.
- Efficiency ratio The efficiency ratio indicates how well a bank utilises its assets in generating revenue, and is calculated as a bank’s expenses (excluding interest expense) divided by the total revenue. A lower efficiency ratio suggests that a bank is operating well, and efficiency ratios at 50% or below are considered ideal. If a bank’s efficiency ratio starts to go up, then it indicates that the bank’s expenses are increasing in comparison to its revenues, or that its revenues are decreasing in comparison to its expenses.
- Loan-to-deposit ratio The loan-to-deposit ratio (LDR) indicates a bank’s liquidity, and is determined by comparing a bank’s total loans to its total deposits. If a bank’s LDR is too high, the bank may be vulnerable to a bank run (mass withdrawals from many clients) due to rapid changes in its deposits. If the ratio is too low, it can indicate that a bank is not meeting its earning potential.
- Price-earnings (P/E) ratio The price-earnings ratio (P/E ratio) relates a company’s share price to its EPS, calculated by dividing the market value per share by the EPS, and can be used to determine the relative value of the company’s shares. P/E ratios tend to be higher for banks that exhibit high expected growth, high payouts, and low risk.
- Price to book (P/B) ratio The price to book (P/B) ratio is calculated by dividing the market price by share by the book value per share, and reveals the market’s valuation of the company in relation to its intrinsic value. P/B ratios are higher for banks with high expected earnings growth, low-risk profiles, high payouts, and high returns on equity.