When investment professionals evaluate banks, they are confronted with bank-specific issues such as to 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.
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.
Another challenge that hampers comparability of ratios across banks is their levels 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 After the Glass-Steagall Act was repealed in 1999, commercial banks were allowed to be involved in investment banking.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 separately each line of business based on its business-specific P/E or P/B ratios and then add up everything to obtain the overall bank's equity value.
Efficiency and Loan to Deposit Ratios
Investment analysts commonly use ratio analysis to evaluate banks' financial health by calculating bank-specific ratios. The most prominent ratios include the efficiency, loan to deposit and capital ratios. The loan to deposit ratio 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. The efficiency ratio is calculated as a bank's expenses (excluding interest expense) divided by the total revenue.
Capital ratios receive a lot of attention due to the Dodd-Frank reform that requires large and systematically 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 banks' vulnerability to sudden and unexpected increase in bad loans.