The Most Important Metric When Analyzing a Bank Stock

There is a tremendous amount of data to look at when trying to analyze a bank stock, so which are the most important to pay attention to? We asked three of our analysts which metric they consider to be the most important, and here is what they had to say.

Patrick Morris: There is seemingly an endless number of metrics to look at when considering whether to invest in a bank. My favorite -- and often first -- to check is the price-to-tangible book ratio, or P/TBV.

Essentially, the P/TBV is the measure of a bank's current market value relative to what it would be worth if every asset were sold, debt was paid, and the intangible assets and equity (such as goodwill) were written off. It provides a picture of how the market values a bank in the same way price-to-earnings is used for consumer-goods and other companies.

As you might suspect, banks such as US Bancorp and Wells Fargo command much higher premiums than Bank of America and Citigroup :

As with any investment, knowing the relative price you are paying for it is critical when you make a decision. Of course, price alone isn't the end-all, be-all of metrics -- the reason US Bancorp and Wells Fargo command such high premiums the result of their remarkable profitability -- but it is absolutely one number to keep an eye on when you're analyzing a bank stock.

Leo Sun: The loan-to-deposit ratio, or LTD, is a key metric of a bank's financial health. To calculate it, divide a bank's total loans by its total deposits. If the ratio is too high, a bank might not have enough liquidity in the event of a crisis; if it's too low, it might not be earning as much as it should from loan interest.

An LTD ratio of between 80% and 90% is considered a decent balance between deposits and loans. For example, the average LTD ratio of the top eight U.S. commercial banks dropped from 101% in 2007, the start of the subprime mortgage crisis, to 84% by the end of 2013.

The LTD ratio can also help us evaluate how economic crisis-stricken countries are faring. At the nadir of the eurozone crisis in 2011, many European banks had LTD ratios between 120% and 220%, meaning that any major outflow of deposits would result in a liquidity crisis. At the beginning of 2014, the European Banking Authority reported that the average LTD ratio across European banks cooled to 113%, its lowest level in four years. That's certainly an improvement, but it's definitely not an "all clear" signal for the region.

Therefore, charting the LTD ratio over time can help investors better understand a bank's liquidity and the overall financial health of the industry.

Matt Frankel: P/TBV and LTV ratio are definitely two very important metrics when analyzing a bank stock, but I prefer to look at numbers like return on equity and efficiency ratio, as they tell us a lot about how well a bank uses its resources to make money. Technically, these are two metrics, but they are pretty closely related.

Return on equity is calculated by dividing a company's net income by the amount of the shareholders' equity. Basically, this shows how effective a company is at earning a profit with its shareholders' money.

And, a bank's efficiency ratio tells us how much a bank spent (its "overhead") to produce its revenue. For example, an efficiency ratio of 60% means that it cost the bank $0.60 to produce every dollar in revenue. Lower efficiency ratio numbers are better.

Looking at Patrick's chart, you'll notice that two banks that are generally considered to be "rock solid," US Bancorp and Wells Fargo, actually trade for very different valuations. Specifically, US Bancorp is quite a bit more expensive on a P/TBV basis.

One main reason is how well US Bancorp uses its resources to make money. During the most recent quarter, US Bancorp produced an annualized ROE of 14.5% and an efficiency ratio of 52.4%. Wells Fargo produced 13.1% and 57.7%, respectively. These are still very strong numbers, but not quite in US Bancorp's league.

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Leo Sun has no position in any stocks mentioned. Matthew Frankel owns shares of Bank of America. Patrick Morris owns shares of Bank of America and US Bancorp. The Motley Fool recommends Bank of America and Wells Fargo and owns shares of Bank of America, Citigroup, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.

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