3 Things Beginning Investors Should Know About the Banking Sector

By Markets Fool.com

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Nobody should invest in anything without understanding what they're getting into -- and bank stocks are no exception. For example, do you know how to tell what banks are vulnerable to recessions and crashes? Do you know the best metrics to gauge the profitability and efficiency of banks? If you answered no to either of these questions, take a look at the advice below, in which three of our contributing writers shed light on the potentially lucrative world of bank stocks.

Dan Caplinger: On its face, the banking business is simple: Earn more money charging interest on loans than you pay to depositors. Yet banks have learned that building up sources of income that aren't related to interest rates can make their financial results less prone to cyclical ups and downs in the credit market, and those institutions that are most efficient at building up non-banking-related businesses offer some advantages over pure retail banks.

At the same time, though, overemphasizing non-banking activities can expose banks to further risks. For instance, wealth management services have been a popular pastime for banks to explore, seeking to capture a greater portion of their clients' net worth. Yet like other asset management companies, banks' wealth-management arms rise and fall with the health of the securities markets, and those cycles don't always run in lockstep with interest rates. Similarly, operations like investment banking and proprietary trading expose banks to different risks. All in all, while diversification can help a bank avoid the most common cyclical rises and falls associated with financial institutions, it can open the door to other influences that you wouldn't necessarily look for without a complete understanding of that particular bank's mix of businesses.

Jordan Wathen: At its core, banking is a simple business of taking deposits and making loans. Banks survive and thrive on their net interest margin -- the difference between what they pay on deposits and earn on their assets.

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One trait of great banks is that they can gather deposits cheaply. It's not glaringly obvious today -- even the most expensive deposits are still quite cheap -- but it's a big advantage to be able to attract low-cost deposits over the long haul. Take a look at Wells Fargo , an exceptional bank by almost any measure. It ended 2014 with nearly $1.5 trillion in funding, which cost it an average of 0.27% per year -- practically nothing.

Banks with cheap funding can make more bad decisions, write off more bad loans, carry more operating expenses, and still manage to deliver excellent returns to their shareholders. And as rates rise, you can bet that they'll be able to resist raising their deposit rates to retain customers. If Wells Fargo's customers haven't yet left the bank because of the 0.08% rate on their savings account, they're unlikely to ever leave. For now, cheap deposits provide a margin of safety against bad lending decisions. In the future, should rates rise, low-cost deposits will pay off big in the form of beefier margins.

Matt Frankel: One thing to know before investing in bank stocks is that the price-to-earnings ratio that's commonly used to value stocks isn't necessarily a good way to value bank stocks.

Generally, stocks with strong projected growth trade for a higher P/E. That's why Googletrades for 27.9 times TTM earnings and IBMtrades for just 11.1 times earnings. However, by this logic, you may think Citigroupwith a P/E of 21.6 is a more "highly valued" bank than Wells Fargo, which trades for just 13.8 times earnings.

Instead, when valuing bank stocks, it helps to have a good understanding of some alternative valuation metrics, such as:

  • Price-to-tangible book value (PTBV): The price of a stock compared to the tangible assets on its balance sheet. This metric excludes such "intangible" assets as patents and goodwill. PTBV is closely related to a bank's profitability, which is discussed more in the "return on equity" section below. However, the main idea is that banks with a higher PTBV tend to be more profitable than those that trade for lower multiples.
  • Return on equity (ROE): A measure of how profitable a company is as a percentage of the money shareholders have invested. For example, if a bank generated $1 billion in net income and the value of all its shares is $10 billion, its ROE is 10%, which is actually the industry benchmark. Banks with ROE of 10% just cover their cost of capital, so they don't command very high valuations. On the other hand, highly profitable banks produce significantly higher ROE than this amount -- sometimes 15% or more. For example, Wells Fargo produced a ROE of about 14% over the past year, which is why it trades for a relatively high PTBV multiple of 2.2, while Citigroup returned just 4% over the past year, a main reason it is actually valued lower than its tangible assets with a PTBV of 0.94.
  • Return on assets (ROA): Especially useful for bank stocks, ROA tells us how much profit a company generates as a percentage of its total assets. Since some banks have assets in the trillions, this is a good way to see how effectively the bank is using those assets to produce profits. In 2014, the industry average ROA was 1.04%.
  • Efficiency ratio: A measure of a bank's expenses as a percentage of its revenue. This tells us how much it costs a bank to generate its revenue, and lower is better. In other words, a bank with an efficiency ratio of 60% spends $0.60 to generate every dollar of revenue.

A good understanding of these four metrics will give you a much better idea of how profitable a bank is and how highly the market values its stock than simply looking at its P/E ratio.

The article 3 Things Beginning Investors Should Know About the Banking Sector originally appeared on Fool.com.

Matthew Frankel owns shares of Google (C shares). The Motley Fool recommends Google (A shares), Google (C shares), and Wells Fargo. The Motley Fool owns shares of Citigroup Inc, Google (A shares), Google (C shares), International Business Machines, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.