Bank Valuation I

Given all the financial turmoil of the markets & the banking system.  There are/were opportunities to be found in the bank stocks.  But a price decline no matter how steep does not necessarily mean its a bargain.  So the question that has come up more recently is:
“how do I know which bank is good to invest in?”

In this series of articles I’ll go over a few simple metrics (quantitative & qualitative) that I used to evaluate whether a bank is worth my investment dollars or not.  The techniques I have used has worked out especially well in the midst of the banking turmoil.  It has helped to avoid investments in financial institutions such as Bear Sterns, Wachovia, Washington Mutual, Citigroup, and many others who have experienced significant financial difficulties.  I’ve used the techniques to invest, before all hell broke loose, and throughout the middle of the ongoing crisis, which has been the best test of the techniques.   Needless to say I am happy with my choices, except that the prices have since risen thereby reducing the price discount currently available.

No single metric alone should be used to make a decision.  Everything together, helps to  give a complete picture of the investment.  Techniques in general, should always be used with financial discipline & emotional intelligence, otherwise they are useless!  Remember that what I present are by no means the only methods available to investors, they are just the ones I use & have found to serve me well.  I hope you can find them useful too!


There are two important things that I always keep in mind during my valuation & analysis:

1.  Keep It Simple: Even before starting to evaluate anything, I always follow this mentality.  I make sure I understand exactly how the business works & operates first.  I don’t invest in anything I don’t understand, or find difficult to make sense of.  This is particularly important because if I don’t know how things work, I wouldn’t know which metrics are the important ones to look at.  Then I move on to the numbers, and if any of my findings confuse me or seem strange, I filter out the entire investment.    My investments need to be easy decisions.  It might be overkill, but it has kept my investments out of trouble.

2. Conservative numbers & viewpoint: There will be numbers that require estimation in order to perform some of the calculations.  These numbers are where many analysts, professionals, and investors will differ.  I find that its always best to use conservative (and even pessimistic) numbers.  Over-optimism is risk introduced by yourself, which can lead to lost investment dollars.  Analysts & many professionals continually fall into the over-optimism trap.


*Note: Most financial websites & data reports, will have these numbers already calculated for you.

Net Interest Margin (NIM) – The difference between interest income generated and the amount of interest paid to the lender.  It is an indication of the firm’s investment decisions compared to its debt situations.   Not too many people are familiar with this term, but investopedia & wikipedia have pretty decent definitions.

A NIM close to 4% (or more) is considered quite good.  Since a major lender of financial institutions are other institutions, the federal reserve, deposits, etc, which have low interest rates, we can see why 4% is good.  Also note that as interest rates rise over the course of a few years, it isn’t unusual to see a firm’s NIM decrease over those same years (and viceversa).


Wells Fargo & Co (WFC) has a 10yr avg NIM of about 5%, Wachovia (WB) has a 10yr avg NIM of about 3.5%.  WFC’s 2007 NIM was 4.74%, while WB’s was 2.94%.  In 2006 (before the market decline) WFC’s NIM was 4.83%, WB’s was 3.12%.  In today’s news (10/3/2008), WFC has agreed to purchase WB, but for about $7 a share.  This is in contrast to what it was trading at months and even a year ago ($24 a share), while it was still announcing billions in writedowns quarter after quarter.  It may have looked like a bargain back then at $24, but clearly, as we will see in this series of articles it was not.


Return On Assets (ROA) – Rising ROA can indicate improving margins, and lower loss rates.  Its normal to see low ROA numbers for financial institutions compared with companies in other industries.  This is due to its relatively larger base of assets.  ROAs of 0.8% to 1.5% is not uncommon.  Other industries can found to have ROAs in the the 5-10% range and above.  For financial institutions, I don’t look at anything with a ROA below 1%.  I like ROAs of 1.5% and above.


US Bancorp (USB) has a 10yr avg ROA of about 1.75%.  In comparison, WB is about 1.03%.  We also see inconsistencies within the 10 years, such as 0.1% in 2000 (while USB had 1.9% in 2000).  Morgan Stanley (MS) was worse with a 10yr avg of just 0.79%.  In 2005 we see the same type of contrasting ROA performance between the banks, well before the market decline.


– Loan Loss Reserve – Is a reserve for losses on loans made.  The amount of the reserve generally rises over time to as the number and total size of all loans grow.  A higher percentage though, may indicate a riskier loan portfolio, or an expected weakening of credit quality (i.e. loan defaults).  An increase in the reserve, means the bank expects an increase in loan losses.  The amount of the reserve can be (but not necessarily) an indication of the amount of losses to come.

As we have seen, all financial institutions (good & bad) have increased the size of their loan loss reserves as defaults and loan delinquencies have risen dramatically.  This is normal practice, as in good economic times the reserve is decreased.  The number really depends on what management decides to put as a reserve and will differ from bank to bank.  However, in good economic times 1-1.5% is not uncommon, while in bad times 2-3% can be found.

We also need to use some common sense when looking at these numbers.  If a bank posts huge writedowns in one quarter due to bad loans, and increases their loan loss reserve by a large margin, it shouldn’t come as a surprise that the next quarter will have more writedowns due to bad loans as well.  Banks loans aren’t made in one quarter, but continually over several quarters or years, which means the results of them will also show up over more than one quarter.  In addition, what we also want to see is that the increases & decreases in the reserve are in line with what management should be doing, & what they are saying they are doing.

Along the same lines, investors should also look at Non-performing assets, net charge-offs, etc.  Because different banks are of different sizes, the absolute number may not tell us a lot.  We need to look at the number as a percentage, which should be low.
– Net charge-offs of average loans outstanding (or net credit loss).
– % Non-performing assets to loans and other real estate
– % of delinquent loans (excluding nonperforming loans).


In 2008Q2 (7/15/2008), USB’s net charge-offs were 0.98%, Non-performing assets 0.68%, and delinquent loans 0.41%.  Each of which are less than 1%.  Usually banks that give total percentages have something to brag about (during a time like this), while ones who only give segmented data (which means you have to piece it all together) try to soften the blow.

Citigroup’s (C) total percentages for 2008Q2 (7/18/2008) were not available, and only segmented percentages were given.  Nonetheless Citigroup’s North American net credit loss ratio increased 51% to 6.53%!  In Latin American 11.41% (a quarterly increase of 60%).  Oddly, the same percentages for EMEA and Asia were not available.  However the stated increases were 61% and 76% (leading me to suspect the actual percentages for net credit loss ratio is staggeringly high).  We can see Citigroup’s management is not very forth coming with their results to shareholders (a warning sign).

Wachovia, Citigroup, Washington Mutual, & others have written down billions due to bad loans as well as asset backed securities and other similar investments during the last quarter of 2007.  They increased their loan loss reserves for the quarters that followed.  It was very likely that in the following quarters more loan related losses would be realized.   Throughout 2008 to date, they posted more such losses.


In the next article Bank Valuation II, I will continue to discuss other financial condition metrics.

Data sources from S&P, Morningstar, Reuters, corresponding bank websites & financial reports.

Thanks & Happy Investing!
The Investment Blogger


3 thoughts on “Bank Valuation I

    1. A proforma financial statements are similar to regular financial statements in format. You also still have the income statement, balance sheet, and so on.

      If you are not familiar with regular accounting, pick up a text book on accounting and learn how to do the financial statements or at least become familiar with them.

      Next perform the forecasts to sales/revenue, income, operational costs, capital expenditures, etc. Basically all the things that will impact the business and show up on the financial statements. Then you create the income statement using your forecasted numbers, then the balance sheet, and other financial statements. Then you’ll have your proforma statements.

      In general, proforma financial statements for banks are not created any differently (format/procedure) than for other companies. You will still go through the same steps. There will be slight differences in the historical statements (items related to banking specifically) that will also carry through to the proforma when you do it.

  1. Mr. Investment blogger,
    Thank you so much for your comprehensive approach to bank valuation. As you know, banks must be evaluated differently than manufacturing companies. Banks are a little tricky to understand. I have mined the Web to learn how to value banks and as far as I am concerned, you are the only one to have done it right.

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