The 10 Most Important Banking Metrics
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PowerPoint Presentation Return on Assets Return on Equity Efficiency Ratio Net Interest Margin NPL Ratio Book Value per Share Loans to Deposits Ratio NCO Ratio Tier 1 Common Capital Price to Book Value Ratio The 10 Most Important BANKING METRICS (Click on the arrow below to view slideshow) Return on Equity: This is the most important metric in all of bank investing. It measures profitability by dividing a bankâs net income by its shareholdersâ equity; the higher the number, the greater the return. Normally, you want to see a figure in excess of 10%, which is generally assumed to mark the threshold between long-term value creation and destruction. Slideshow by John J. Maxfield, The Motley Fool Return on Assets: This number is similar to return on equity but it doesnât reflect the impact of a bankâs leverage. Because banks are typically leveraged by a factor of 10 to 1, in order to generate a 10% return on equity, a bank must earn the equivalent of at least 1% on its assets. This has long been one of the bank industryâs most commonly cited benchmarks. Slideshow by John J. Maxfield, The Motley Fool Net Interest Margin: A bank is a leveraged fund that borrows money at low short-term rates and then invests the funds into higher interest-earning assets. By doing so, a bank earns ânet interest income.â If you divide this by a bankâs earning assets, you get its net interest margin, which shows how much the business yields on its invested assets. Slideshow by John J. Maxfield, The Motley Fool Efficiency Ratio: Warren Buffett has intimated in the past that there are two ways a bank can generate outsized returns, one of which is to be a âvery low-cost operator.â A bankâs success at managing expenses is gauged by the efficiency ratio, which divides a bankâs operating expenses by its net revenue -- lower is better. Ideally, youâre looking for ratios under 60%. Slideshow by John J. Maxfield, The Motley Fool Nonperforming Loans Ratio: Because banks are so leveraged, itâs critical that they only invest in assets with little risk of default. Analysts use the NPL ratio to measure how lenders perform in this regard. Itâs calculated by dividing a bankâs nonperforming loans by total loans. A good rule of thumb is that the NPL ratio should be less than 1% through all stages of the credit cycle. Slideshow by John J. Maxfield, The Motley Fool Net Charge-Off Ratio: A close cousin of the NPL ratio, the NCO ratio measures what happens after loans actually default, triggering a bankâs obligation to charge the loans off against its capital. Because this metric factors in the recovery of collateral, a bankâs NCO ratio should be smaller than its NPL ratio. If not, the bank probably isnât focusing enough on collections. Slideshow by John J. Maxfield, The Motley Fool Loan-to-Deposit Ratio: This metric expresses a bankâs loans as a percent of deposits. In doing so, its purpose is to measure liquidity. Banks with a high ratio have less core funding to cover withdrawals or other exigencies that arise. Banks with too low of a ratio arenât maximizing the spread between their cost of funds and interest on earning assets. Slideshow by John J. Maxfield, The Motley Fool Tier 1 Common Capital Ratio: Regulators assess a bankâs strength first by looking at the size and composition of its capital base. The most important metric in this regard is the tier 1 common capital ratio, which compares a bankâs core equity capital (common stock less most types of preferred stock) to its risk-weighted assets. The regulatory minimum is 4.5%. Slideshow by John J. Maxfield, The Motley Fool Book Value per Share: When you purchase shares of a bank, youâre staking a claim to a portion of its shareholdersâ equity, or book value. The size of that claim is a function of (1) the number of shares you buy, and (2) the amount of book value each share entitles you to. As the next slide explains, this metric plays a leading role in the valuation of bank stocks. Slideshow by John J. Maxfield, The Motley Fool Price-to-Book-Value Ratio: To determine how much you should pay for a bankâs shares, you look to the price-to-book-value ratio. Depending on where weâre at in the credit cycle, a typical bankâs shares will trade for between 0.5 to 2.5 times book value, with 1 times book value serving generally as the minimum threshold for banks that earn at least 10% on their equity. Slideshow by John J. Maxfield, The Motley Fool Return on Assets Return on Equity Efficiency Ratio Net Interest Margin NPL Ratio Book Value per Share Loans to Deposits Ratio NCO Ratio Tier 1 Common Capital Price to Book Value Ratio Looking for more information like this? The Motley Foolâs mission is to help the world invest better. Weâve done this for 20 years by thinking long term and outside the box â even if that means turning Wall Street on its head. 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