It can be tricky for the average investor to evaluate an investment bank properly. The general rules of stock-picking apply – profitability is good, rising dividends are better, and cash flow should be sustainable – but there are also some additional metrics with particular relevance for investment banks. These include shareholders' equity metrics, the composition of liabilities, debt to total capital, return on capital employed (ROCE) and return on assets (ROA).
Successful Investment Banks
The investment banking industry makes up a large part of the overall financial sector of the economy, particularly when it comes to the capital and credit markets. Successful investment banks identify opportunities to assist promising companies to grow even faster and create liquidity in the stock market.
At a basic level, investment banks work with larger organizations or institutional investors. They offer advice, investment services, help with raising or managing new capital, or sometimes act as principals.
These tend to be substantial financial institutions with solid ties to Wall Street. Investment banks earn much of their revenue through fees or commissions. They also have their portfolios and can profit from their holdings.
To analyze an investment bank, you need to understand how efficiently it can acquire assets, make investments, manage risk, and subsequently turn a profit for shareholders.
The Price-to-Earnings Ratio
Think of the price-to-earnings (P/E) ratio is the price you have to pay to get access to company earnings. The P/E ratio is calculated by dividing price per share by earnings per share (EPS). This information should be available in every major investing website or publication.
Return on Assets
The ROA metric reveals the earning capacity of profit by an investment bank to its total assets. Use this to gauge how effectively management uses the bank's existing asset base to make profits for shareholders. Calculate ROA by dividing the investment bank's net income by its average total assets. Since income is in the numerator, higher ROA figures are better.
Return on Equity
Probably second in popularity only to the P/E ratio, the return on equity (ROE) ratio helps express how effectively a company rewards its shareholders for their investment. For example, consider a company that earns $500,000 in net income and has an average stockholders' equity of $10 million. You can calculate ROE by dividing $500,000 from $10 million to get 0.05, or 5%. This means every $1 of shareholders equity turns into 5 cents in profit. Like ROA, higher numbers are preferred for ROE.
Debt to Total Capital
The debt to total capital ratio describes how much debt is being used to hold the investment bank together. The ratio is calculated by dividing total debt by total capital. A higher figure means that there is a higher level of risk built into the company's financial structure. Analysts similarly use this ratio to the debt/equity ratio.
Return on Capital Employed
ROCE is another ratio that emphasizes efficiency, but it is particularly suitable for an investment bank. Investment banks bring in a lot of service revenue, but they often hold substantial assets and tie themselves to substantial liabilities. ROCE is calculated as earnings before interest and tax divided by total capital employed. Higher figures reflect a capital strategy that is profitable and efficient.
The Current Ratio
Think of the current ratio as a modifier to the debt to total capital. Even a highly leveraged investment bank could be secure if it has strong, consistent cash flow for financing its obligations. The current ratio is equal to current assets divided by current liabilities. This directly measures the ability of the company to pay back short-term debts and payables with its liquid assets.