When investment professionals evaluate banks, they are confronted with bank-specific issues such as how to measure debt and reinvestment needs. Banks use debt as a raw material to mold it into other profitable financial products, and sometimes it is not clear what constitutes debt.
Financial companies also tend to have very small capital expenditures and depreciation, plus not all typical working capital accounts are present. For these reasons, analysts avoid using metrics involving firm and enterprise values. Instead, they focus on equity metrics, such as price-to-earnings (P/E) and price-to-book (P/B) ratios. Analysts also perform ratio analysis by calculating bank-specific ratios to evaluate banks.
- Banks come with their own specific issues, such as debt levels, a loan business, and reinvestment needs.
- Because banks have unique attributes, certain financial ratios provide useful insight, more so than other ratios.
- Common ratios to analyze banks include the price-to-earnings (P/E) ratio, the price-to-book (P/B) ratio, the efficiency ratio, the loan-to-deposit ratio, and capital ratios.
Important Ratios for Evaluating the Banking Sector
P/E and P/B Ratios
The P/E ratio is defined as market price divided by earnings per share (EPS), while the P/B ratio is calculated as market price divided by the book value per share. P/E ratios tend to be higher for banks that exhibit high expected growth, high payouts, and low risk. Similarly, P/B ratios are higher for banks with high expected earnings growth, low-risk profiles, high payouts, and high returns on equity. Holding all things constant, return on equity has the biggest effect on the P/B ratio.
Analysts must deal with loss provisions when comparing ratios across the banking sector. Banks create allowances for bad debt that they expect to write off. Depending on whether the bank is conservative or aggressive in its loss provision policy, the P/E and P/B ratios vary across banks. Financial institutions that are conservative in their loss provision estimates tend to have higher P/E and P/B ratios, and vice versa.
When utilizing ratios to compare banks, one has to compare banks of similar characteristics. Comparing a large investment bank to a savings and loan would not provide any insight as both are completely different types of entities with different goals, services, and customers.
Another challenge that hampers the comparability of ratios across banks is their level of diversification. After the Glass-Steagall Act was repealed in 1999, commercial banks were allowed to be involved in investment banking. Since then, banks became widely-diversified and are commonly involved in various securities and insurance products.
With each line of business having its own inherent risk and profitability, diversified banks command different ratios. Analysts usually evaluate each line of business separately based on its business-specific P/E or P/B ratios and then add up everything to obtain the overall bank's equity value.
The efficiency ratio is calculated as a bank's expenses (excluding interest expense) divided by the total revenue. The main insight that the efficiency ratio provides is how well a bank utilizes its assets in generating revenue. A lower efficiency ratio signals that a bank is operating well. Efficiency ratios at 50% or below are considered ideal. If an efficiency ratio starts to go up, then it indicates that a bank's expenses are increasing in comparison to its revenues or that its revenues are decreasing in comparison to its expenses.
The loan-to-deposit ratio (LDR) indicates a bank's liquidity; if it is too high, the bank may be susceptible to a bank run due to rapid changes in its deposits, meaning it may not have enough funds to cover its requirements. If the ratio is too low, it can indicate that a bank is not meeting its earning potential. The ratio is determined by comparing a bank's total loans to its total deposits.
Capital ratios receive a lot of attention due to the Dodd-Frank reform that requires large and systemically important financial institutions to undergo stress tests. The capital ratio is calculated as a bank's capital divided by the risk-weighted assets. Capital ratios are usually calculated for different types of capital (tier 1 capital, tier 2 capital) and are meant to assess a bank's vulnerability to sudden and unexpected increases in bad loans.
The Bottom Line
Banks are a different breed than other financial institutions and corporations and come with their own unique attributes, such as their loan business and debt levels. Because of these specific characteristics, utilizing certain financial ratios makes evaluating a bank more fruitful for investors and financial analysts.