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If you're thinking about buying bank stocks, or any kind of stocks for that matter, few things are more important than profitability. To make things easy, here's a list of the 10 most profitable big banks in America.
*TTM: trailing 12 months. Data source: YCharts.com.
There are a few points to note here. First, these banks are all members of the KBW Bank Index, which tracks two dozen of the nation's biggest banks, ranging from Commerce Bancshares, which has $25 billion in assets on its balance sheet, up to JPMorgan Chase, which has a $2.5 trillion balance sheet.
Second, at least in the context of investing, profitability doesn't just mean how much a bank earns. If that were the case, then the biggest banks on any list would almost invariably also be the most profitable.
Given this, it's important to look beyond a bank's earnings to determine how profitable it is on a relative basis. That's why the above list isn't sorted by net income, but instead by return on equity. This placesU.S. Bancorp (NYSE: USB), Wells Fargo (NYSE: WFC), and Fifth Third Bancorp (NASDAQ: FITB) at the top despite the fact that they're aren't the three biggest banks on the KBW Bank Index.
Return on equity is calculated by dividing a bank's net income by its shareholders' equity. In this way, it shows how much profit a bank earns from every dollars' worth of equity. In U.S. Bancorp's case, it's earned $0.14 from every dollar in equity over the last 12 months. Meanwhile, Wells Fargo has earned $0.13 from each dollar and Fifth Third Bancorp is at $0.12 per equity dollar.
This makes it easy to determine how effective, say, U.S. Bancorp's management is relative to Wells Fargo's, even though Wells Fargo is roughly four times larger than U.S. Bancorp. And the same is true for Fifth Third Bancorp, which is less than a tenth of Wells Fargo's size.
The final metric that's worth considering when you're assessing a bank's profitability is return on assets. Because banks are so heavily leveraged, typically by a factor of 10 to 1, it can be hard to tease out whether one bank earns more than another simply because it uses more leverage.
The way to tell whether this is the case is to look at return on assets, which is calculated by dividing a bank's earnings by its total assets, as opposed to its shareholders' equity. It may go without saying, as you can see in the table, but there's bound to be overlap between these two profitability figures.
In this case, regardless of whether we look at return on equity or return on assets, U.S. Bancorp, Wells Fargo, and Fifth Third Bancorp remain at the top of the list. The only difference is that, excluding leverage, Fifth Third outperforms Wells Fargo.
The lesson here for investors is twofold. First, profitability should be a primary consideration when picking bank stocks. And second, that profitability is about more than just profits and is dependent, in no small part, on how you measure it.
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John Maxfield owns shares of US Bancorp and Wells Fargo. The Motley Fool owns shares of Wells Fargo. The Motley Fool recommends Cullen/Frost Bankers. 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.