The financial sector, for some more interesting, for some less. But did you know that this sector is currently the second-largest by market capitalization? The first place takes information technology. According to Fidelity, the financial sector makes up almost $9 trillion of the market capitalization of the stock market, This is more than 13% of the market. Therefore, it is important to know how to value the bank stocks of America.
For many investors, the financial sector is in the “dark” because they don’t understand the financial industries or how to value those companies. In this article, you will learn more about the largest industry within the financial sector, and these are as you might have guessed – banks.
The banking industry makes up a $4 trillion market capitalization. This is just under 50% of the total financial sector.
Banks can seem like complicated businesses, and they often are. However, if you look at simplified definitions of how these businesses make their money, they are easy to understand. With that in mind, here’s an overview of the different types of banks and some important metrics investors that value banks should know.
- Commercial banks: Banks that make revenue by lending money to customers and profiting from interest on those loans.
- Investment banks: Banks that advise clients on mergers and acquisitions (M&A), facilitate equity and debt offerings, manage wealth for high-net-worth clients and businesses, trading in equities, fixed-income securities, currencies, and commodities.
- Universal banks: Those that are a combination of the other two.
There are hundreds of banks available to buy on the stock exchanges, and they are all different in some way. To analyze them and distinguish them, various ratios are used, which we will explain next.
This is perhaps the most important section on banks’ balance sheets. Simply put, banks are the loans and securities they hold that can be seen in the assets. These financial instruments will drive the future profitability of a bank and they can also ruin a bank’s business.
If you see that a large part of the bank’s assets are loans, it means that the bank is more engaged in traditional business. This figure is often 50% or more if a bank focuses on traditional consumer banking.
On the other hand, banks with a lower number of loans in total assets, indicate that the bank provides the products as an investment bank. In that case, the bank will have more securities in its assets.
Insight into the bank’s assets provides a basis for knowing what the bank is doing. After that, it is necessary to go deeper into the analysis of the bank, and that is to see why the bank is doing what it is doing.
Metrics used to analyze assets of a bank: Net Loan / Total Assets, Securities and investments / Total Assets, Cash / Total Assets.
By reviewing the liabilities in the bank’s balance sheet, you can see from which sources the bank is financed. It would be best for the bank to have the largest possible source of financing from deposits, given that this is how they get money cheaply. The second way is from short-term and long-term debt which you can also see in this section.
Deposits can be further divided into:
- non-interest-bearing deposits that are common in checking accounts. For these deposits, banks get money cheaply;
- interest-bearing deposits which are most often fixed term or other.
This allows us to answer some questions that came to our minds while looking at the bank’s assets. In circumstances that a bank is unable to attract enough deposits or even non-interest deposits, it may therefore be more interested in providing investment banking services.
In addition to this, there are two important metrics you can use here, Total Deposits / Liabilities, Total Debt / Liabilities. These metrics help us to see banks total deposits compared to total liabilities. If a bank’s deposits make up a high percentage of its total liabilities, it means that the bank has access to low-cost capital. On the other hand, the bank can have more of its liabilities in the form of debt, and that could indicate a higher interest rate paid and more risk for you as an investor.
Metrics used to analyze liabilities of a bank: Total Deposits / Liabilities, Total Debt / Liabilities.
Bank’s Income Statement
There are two main categories of bank income:
- interest income which is income from loans provided.
- noninterest income wich is all other income bank gets. These can include investment banking fees, service charges, processing fees and so on.
One of the most important lines to analyze in a bank’s profit and loss account is net interest income. This line tells you the profitability of the traditional banking business or the difference between the interest they collect and the interest they pay on deposit.
The other important line in the income statement is noninterest income which will be more important for investment banks.
There is also an expense side that is good to look at to calculate business efficiency. You can divide the noninterest expense (which stands for salaries, operating costs, etc.) by the total revenue for it. If the ratio is smaller that means the bank needs less noninterest expense for each unit of income, which is of course better.
Metrics used to analyze the income statement of a bank: Net interest income / Net Loan, Non-interest expense / Total Revenue.
How To Value Bank Stocks of America Using Instrinsic Value
The last section that is worth mentioning in this article when analyzing banks is the calculation of their intrinsic value. The obvious reason why you want to know intrinsic value is to buy bank stocks for less than their actual value.
While I would personally use DCF or discounted cash flow model which is most used for most industries. But with the financial sector, including banks, is a different story. Because of the nature of their capital structure, it is difficult to measure both debt and equity, which makes estimating cash flows a problem.
However, using valuation metrics for this case can solve the problem. Most used metrics to value banks are known to be a price to book value and price to tangible book value.
Book value stands for equity. If you buy book value that means you are buying stocks at a price equal to their equity.
A slightly more useful metric is the use of a price to tangible book value. This ratio excludes out a bank’s intangible assets such as goodwill and preferred stock equity (which you as a common shareholder wouldn’t get).
The reason for this is because you can’t sell goodwill and therefore you want to know what is the real value of the business if something goes wrong.
Metrics used to calculate intrinsic value: Price / Book Value, Price / Tangible Book Value.
To Sum Up
The financial sector is currently second on the list by market capitalization. Banks by themselves can be a great investment but for individuals who know how to value the bank stocks of America. It is certain that these financial instituions function differently than other companies. That’s why we have different valuation methods explained in this article.