As an answer to a question I received on Facebook regarding investing in banks:
I think bank stocks are very tricky to evaluate, which is why I almost always stay away from them (also why I didn't get burned during the financial crisis). The reason I say that is because you never really know where they invest their money, we know that banks have deposits and in turn they loan out that money for mortgages and so for a higher interest. The tricky part is figuring out just how leveraged a bank is and where they are investing. Banks as we have recently seen are not very liquid, they have a lot of assets, but they can't really do too much with those assets in time of need. (other than write off the losses and so on). When Lehman brothers had fallen so much I was looking at investing in them, but I couldn't understand what they did or where they got their money. So I had to stay away.
In dream world banks should be easy to evaluate, you should be able to see how much money they have in deposits and calculate how much they can loan out from that. At one time I believe in the USA a bank could only loan out 12x what they have in deposits, that got raised under president Bushes era to something like 30x (please correct me if I'm wrong.. going from memory here). However in reality, evaluating banks has become extremely difficult as banks now not only loan out money for mortgages but also have hedge funds, mutual funds, brokerages and everything else under the sun. It's very hard to trace the money and the security behind that money when it comes to the banking sector.
One last thing before getting to the evaluation of the banking sector, one of the main reasons behind the whole banking crash is these mortgage backed securities. While the subprime loans were a cause in the beginning, I think the real answer can be found in Peter Lynch’s Beating the street.[1]
Anyway, to the evaluation:
We can start with what Peter lynch felt was important and that is the equity to assets ratio which needs to be higher than 5%,
“The most important number of all is the E/A ratio. This measures financial strength and survivability. The higher the E/A, the better. E/A’s have an incredible range, from as low as 1 or 2 (candidates for the scrap heap), to as high as 20. An E/A of 5.5 to 6 is average, but below 5, you’re in danger zone for ailing thrifts”.[2]
Another important factor is the Book value, here is where it can get tricky, as you really need to try and figure out what it’s high risk assets are, and how large of a portion are those assets in the bank. Many banks did not considered their investments in mortgage backed securities as high risk loans, which means you could not look at the annual report and see exactly how much risk these assets carried.
Once you figure out what the actual book value is, and how many high risk investments the bank has, than you can look at such factors as the P/E value, (lower the better), a high dividend yield is also very good to see (with low payout ratio, under 60%) This shows the bank is earning cash and is able to pay it’s dividend without having to take out loans in-order to pay the dividend. And a good growth rate both organic and other.
Warren Buffett usually looks at the Return on Assets ratio where he discusses a banks' profitability - equity to assets is important when considering banks' sustainability. The return on assets will ordinarily be about 1%. If a bank has a higher than 1% ratio we can consider this to be a great bank. The assets are its loan portfolio and so the return on assets represents the margin it makes after costs. The return on assets is a product of the different in rates between funds borrowed and lent and the costs per assets. You can understand future profits by considering the return on assets and the growth in assets.
Also don't forget free cash flow (fcf) this is as important with banks as it is with any sector or business.
For a better understanding of investing and evaluating in banks I really suggest reading Beating the street and even watching Jim Cramers Madmoney as he really breaks down the banking sector from time to time which I find very helpful.
Personally I try and stay away from banks, I just don’t trust the assets that banks report. I don’t understand how modern banks function and how they are to be evaluated. The days of just savings and loan banks don’t really exist anymore, this was all to evident in the recent banking crash. I can invest in technology because I understand it, I can invest in industrials, energy and cyclical because I understand them. However with banks I just can’t take that risk and my pessimism has saved my ass on many occasions. With that said I have invested in Goldman sach at $70.00 a share and am currently investing in JP Morgan. These banks I understand, and have made a killing on them.
[1] In Peter lynch’s Beating the street starting on page 265 he goes into a discussion about how the “new Freddie mac” had started on something new. Packaging mortgages and selling them off to other investors. While Peter viewed this as something new and great that would lead to amazing profits (which it did). We can also see the after effects of it.
[2] Peter Lynch, Beating the street. Simon & Schuster paperbacks. 1993. Pg 201-205
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