24/06/2024 4:12 PM


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The Metrics to Watch When Researching Financial Stocks

In this podcast, Motley Fool senior analyst Jason Moser and Motley Fool contributor Matt Frankel dive deep into the metrics they use to judge financial companies. And they provide comparison guidelines for investors. 

They discuss:

  • Why the price-to-earnings (P/E) ratio is less important than you may think.
  • The nuance of judging a bank’s efficiency.
  • One metric to watch for evaluating any fintech company.

To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on March 27, 2022.

Matt Frankel: [MUSIC] The reason that these online banks say, Axos Financial, which is my bank, the reason they haven’t taken over and people aren’t willing to fully switch is because the customer service, not just the branches, the customer service really hasn’t caught up because that adds expenses. Half of the branch expenses is labor cost. [MUSIC]

Chris Hill: [MUSIC] I’m Chris Hill, and that was Motley Fool contributor, Matt Frankel. If you’ve been looking for a deeper dive on financial stocks, this one’s for you. Motley Fool Senior Analyst, Jason Moser, talks with Matt about the metrics they use to judge financial companies and why those numbers are just one part of the story. This one gets into the nitty-gritty of valuing financials. Looking at things like take rates, non-performing loans, and efficiency ratios. But they start with the fundamentals and why book value is so important. [MUSIC]

Jason Moser: [MUSIC] We focus I think primarily on things like banks and insurance to get started here because that’s such a big universe. But this seems like it’d be a really fun show to dive into some of those nerdy metrics that we as analysts always focused on in order to gauge the health of all of these different financials-related companies. You’ve put together I think a very impressive list here of metrics that we talk a lot about, that we follow, that we track. We want to dig into what these metrics are, explain what they are, what they mean, and talk a little bit more about how we use them in our analysis of these financial-related businesses. First up, we want to talk about book value. We hear a lot about book value when we talk about insurance companies, but it’s not limited to just insurance companies. But talk a little bit, what’s book value?

Matt Frankel: Think of book value in the same context as equity in your house. It’s a balance sheet metric. If you buy your house, you put a down payment, and you could take a mortgage for the rest. The difference between your home’s value and what you owe the bank is your equity. Same concept for book value. It’s the difference between the assets a company owns and its liabilities. This is not a financial-specific metric. It’s just most useful for evaluating companies like financials, where traditional metrics like earnings don’t make sense or the assets a company owns doesn’t really match up to the actual value of the business. For example, banks are only required to keep something like 10 percent of capital on their books for all their loans. You might see a bank with $3 trillion of loans and a $300 billion market cap, so it doesn’t really match up. Book value tells you really just the value of the business. Let’s say, JPMorgan Chase decided to shut it’s stores and go out of business, sell-off everything it owns and pay off its debts. Book value would be what’s left at the end of that.

Jason Moser: Aha. When we look at book value, and we didn’t try to convert that into a metric that we can use to analyze a bank or an insurance company, what’s the easiest way to translate that into a metric that we can follow?

Matt Frankel: Price-to-book value is one of my favorite bank valuation metrics, and I’ll tell you why. Price-to-earnings is the most common metric we use to value stocks, the P/E ratio. It doesn’t work well with banks because their earnings aren’t always reflective of what the business is doing. I’ll give you an example. In 2020, when the COVID pandemic hit, what were all these banks doing? They were setting aside billions of dollars in reserves in anticipation of loan losses. Well, those billions of dollars in reserves countered against their earnings, even though they weren’t really spending anything, and the losses turned out not to even really materialize. That countered against their earnings and made it looked like they had bad quarters. I think Wells Fargo actually ran at a loss in the second quarter of 2020 because of this. Bank of America lost half of its earnings in the second quarter of 2020 because of a reserve issuance. Book value just cuts through that. It’s a market system with one-to-one metric. It tells you how much a bank is trading for based on the actual value of its assets minus liabilities.

Jason Moser: I know that’s also a metric we like to use for insurance companies. It’s interesting you bring up that reserves issue with banks because that’s something we’ve really talked a lot about here the last couple of years. It was interesting to see how so many of these banks really did put a lot of that money aside, and you’re right. It counted against them. Then that was a catalyst we knew was like a coil spring almost. We knew that if the situation improved, and the banks didn’t need all that money they set aside, well then they could release those reserves. It really did play out on those earnings-per-share numbers. It’s always something to keep in mind. The market’s not done. We know that the market’s forward-looking. It is taking that into consideration though, don’t you think?

Matt Frankel: Sure. But when you see a bank trading at say, Goldman Sachs right now trades at six times earnings, that’s not exactly the case. [laughs] Bank of America’s trading for a low double-digit multiple of its earnings per share, but that includes a lot of those reserve releases that you’re mentioning, so it doesn’t really tell the whole story. Price-to-book really levels the playing field along with that.

Jason Moser: Now, tangible book value is something very similar, but it’s a little bit different. Explain the difference between book value and tangible book value.

Matt Frankel: Book value includes everything a company owns, all of its assets. Tangible book value includes the assets that are fairly easy to sell or determine a price of. For example, banks can sell their loans to other banks, so that’s a tangible asset. If a bank owns its office building it operates in, then that’s a tangible asset. If it owns patents on designs, that’s not a tangible asset because it’s not something that’s readily monetizable. Goodwill that comes from acquisitions, you’re buying a brand name or something like that, those are not tangible assets. Bank of America bought Merrill Lynch’s brand name during the financial crisis, that’s an asset, but it’s not a tangible asset. It excludes things like that, and just focuses on the things that it could actually sell, if it needed to, or could monetize fairly easily.

Jason Moser: Next up, we got return on equity. Return on equity, it makes me think of Berkshire Hathaway and Warren Buffett. I know that’s a metric that Buffett likes a lot. What is return on equity? Why does Buffett like return on equity so much?

Matt Frankel: It’s a profitability metric. It shows how efficiently a bank or any company is using its shareholders’ equity to generate a profit. For example, if a bank’s book value is say, $300 billion, and it’s generating $30 billion in annual profit, that would be at 10 percent return on equity. It’s a measurement of how effectively they’re using shareholders’ money to make money.

Jason Moser: I got you. In return on assets, something similar, a little bit different, I’ve used return on assets personally in gauging the value of banks before. But return on assets, something similar, a little bit different though than return on equity.

Matt Frankel: Return on assets doesn’t incorporate leverage really. It just looks at the assets on a bank’s balance sheet say, loans, things like that. If a bank has $2 trillion of loans, it might want to produce one percent of that or $20 billion in a return. The general rule is return on assets, you want to see the benchmark be 10 percent or higher. That will be considered a profitable bank. Higher the better, obviously. Return on assets, you’d want to see a one percent or better, which is considered the industry benchmark.

Matt Frankel: Higher is better, most of the big four banks are in the 12-14 range for return on equity most of the time, and in the 1.1-1.4 range for return on assets. That’s where you want it to be.

Jason Moser: Now, with banks we see in earnings calls often they’ll talk about the efficiency ratio, and with banks and insurance companies, efficiency really is the name of the game. How is the efficiency ratio calculated and what does it tell us?

Matt Frankel: First start with the efficiency ratio lower is better. Efficiency ratio is how much money a bank of spending to generate its revenue. If a bank is spending 70 cents for every dollar of revenue it’s generating, its efficiency ratio would be 70 percent. If it’s only spending 60 cents to generate each dollar of revenue, it’s efficiency ratio would be 60 percent, so that’s better, it means it’s costing less money to generate that revenue. Now, brick-and-mortar banks are at an inherent disadvantage over FinTechs and banks that don’t have branches, say markets by Goldman Sachs or SoFi or those banks. I roughly say about a 60-70 percent efficiency ratio is what you should expect from a branch-based bank, and something in the 50 percent ballpark would be more of a FinTech bank efficiency ratio.

Jason Moser: Yeah, and it feels to me like, we’ve seen plenty of stories out there over the last several years about banks wanting to reduce that footprint. Not rely on such a heavy physical infrastructure banking centers. [LAUGHTER] Honestly Matt, I live my life trying to figure out how to not good or bank, etc. I don’t want to go to the DMV, I don’t really want to go back either, do you feel like going forward because I feel like that physical presence is going to continue to come down overtime. It just seems the only direction that it can go. Do you feel like that’s an opportunity for banks when it comes to something like the efficiency ratio? Is that going to change the importance I guess, or the weighting of how we look that efficiency ratio?

Matt Frankel: For sure, efficiency ratios are going to trend downward, meaning in the positive direction for the foreseeable future. It’s a fine line banks have to walk between providing customer services people expect, NB running an efficient operation. The reason that these online banks say Axos Financial which is my bank, the reason they haven’t taken over and people aren’t willing to fully switch, is because the customer service, not just the branches, the customer service really hasn’t gone up because that adds expenses, it’s half of the branch expenses is labor cost, so if you have a customer service call center, that’s a labor costs that you have to add in. It’s a fine line between balancing the customer service people expect, because on occasion there is reason to go into a bank. I will now instead of Bank of America branch last week, and for the first time in like a year and it looks a lot different than it used to. [LAUGHTER] They got rid of the drive through in most of their branches, and there’s one teller, there’s not even like a counter, there’s like one window with the teller in it though. But it’s not necessarily about reducing the branch count, it’s about focusing on the branches that you need the most and that are closest to most of your customers, and reducing waste and running them in an efficient manner as possible.

Jason Moser: Yeah, that makes a lot of sense. That definitely makes a lot of sense the customer service is hard in any line of work. Certainly when it comes to banking, it’s very understandable that folks get emotional about their money, that’s something that we talk often with our members here at the Fool. Money is just an emotional thing and sometimes you really do need that physical presence, you need to be able to see the person that you’re speaking with and understand what they’re telling you in trying to solve a problem, and that is something I feel like the FinTechs of the world where the customer services is just you’re right, it’s not caught up yet and I guess at some point it will have to.

Matt Frankel: I will say like last year when I bought my vacation outside the wire, about $100,000 for a down payment. I don’t want to do that through my computer, [LAUGHTER] that’s something I’m going to drive to the bank, I want to be sitting there, I want to verify the information on the teller screen before it hits go, that’s something I want to drive to the bank and do. Or I at least want to talk toward live person, which was something online-based banks is a lot tougher than you think it would be, [LAUGHTER] so there are some things you want to drive to the bank for. Like I said, it’s going to be a balancing act by some of these big banks over the next couple of decades.

Jason Moser: Non-performing loans in charge-off ratio, we talk about banks obviously they make money by lending, and it feels like the charge-off ratio and non-performing loans are connected in that way, but explain the charge-off ratio and why it matters particularly in the banking industry.

Matt Frankel: Yeah, I’m glad you actually want those two together because they’re two degrees of the same thing. Non-performing loans are just loans that aren’t doing what they’re supposed to do. In other words, if a customer agrees to pay you five percent interest, and make monthly payments for 60 months, if those monthly payments stop coming for a few months, that’s a non-performing loan. During the COVID pandemic that became a really fully with metric because people got loan forgiveness, they’d asked the bank can I postpone payments for three months, things like that, so that would count as a non-performing loan in a lot of cases. But some banks break it down at the 30-day non-performing loans, meaning loans that have missed one payment, 60-day non-performing loans, loans that miss two payments, it gives you an overall feel of how their loan book is doing. Charge-offs are loans that have been deemed uncollectable that they’re writing off. Now, especially with big banks, this is a cost of doing business, not everyone is going to pay their loans back for one reason or another. People lose their jobs, their expenses get out of whack, they get overloaded in debt, whatever the reason. You’re not going to collect a 100 percent of your loans, but you want that number to be as low as possible. Most major banks are in the 0.5 percent range, meaning that out of every million dollars of loans they make, they’re charging off about 50,000, I think is how it works out about $5,000 out of every million there anticipate charge-offs. The non-performing loan rates usually considerably higher because late payments happen more often than people just flat out not paying their loans. Those are two metrics that you can use in conjunction to excessive banks credit quality and the trend is really important there because during say, the financial crisis, you will see the charge-off ratio shoot up, that didn’t really happen during the COVID pandemic. You get a feel for where they might release some reserves like we mentioned earlier, or when they might need to up their reserves if things are getting bad, it tells you the trend in the industry as well.

Jason Moser: When I think of this charge-off ratio and the non-performing loans, in the stereo typical bank, old stodgy bank metric, it also feels like these metrics really apply today to this burgeoning BNPL space, the buy now pay later where you’re seeing companies actually built on that offering. Oftentimes they are providing the underlying technology and service and then they’re partnering with banks on the back-end there to be able to help fund those loans. Because ultimately that’s what buy now pay later is, you’re lending a consumer money to be able to purchase something now and pay it back in installments. I guess the firm is probably the company that stands out as one of the better known companies in the space. That’s something that they have to take into consideration too. They go into that knowing that consumers aren’t going to pay back every one of those installment loans.

Matt Frankel: For sure. I mentioned that 0.5 percent is typical for a big bank. That’s not typical for, say, at a firm or [laughs] a buy now pay later company. They are expecting 5 percentish charge off rates. That’s just the nature of the business. It’s the same with credit lenders that are credit card heavy. Like Capital One, for example, which makes most of its money off credit cards, has a much higher charge-off rate than, say, Wells Fargo where that’s so much smaller part of its business. So it depends on the mix of a bank’s business. I guess a credit card lender’s expected to have to eat more debt, which is why they charge 18, 19 percent interest on credit card loans, [laughs] as opposed to companies that are primarily auto lenders, which charge 4 or 5 percent interest because they know they’re not going to have to write-off that much of that debt, and if they do, they can repossess the cards, it’s a secured lending product. It depends on the nature of the business and the mix of loans that they are dealing with.

Jason Moser: We talk a lot about net interest margin during earnings season. That gives us a good insight as to how profitable a bank is, how much money they’re making on those loans. It feels like it’s been a drag here for a long time because the interest rate environment has been so low, obviously a big point of discussion here over the last several months and I think we’re going to be talking about it more here in 2022 and beyond is the raising of interest rates. Talk about net interest margin, what it is and how it’s connected to this interest rate conversation.

Matt Frankel: Yes. Net interest margin, think of that as the bank’s profit margin. If a bank is collecting 5 percent interest on its loans, paying 1 percent on deposits, the difference between that is 4 percent. Subtract whatever administrative costs are involved in those loans and then you get your net interest margin. It’s also called the interest spread between what they’re paying and what they are collecting. There is a couple of reasons this is important. One is why rising interest rates can actually be good for banks. So far in 2022, especially all of a sudden, investors are seeing why bank stocks could be good to have in your portfolio during times like these. But it’s also worth noting that bank revenue growth isn’t always indicative of the growth of the business. The reason is because interest rates fluctuate. For example, if a bank’s loan book rises it by 10 percent, they go from one trillion to $1.1 trillion in loans, but interest rates declined significantly. You can actually see their revenue fall even though their business is actually growing nicely. So the net interest margin can help put that into perspective. When you see their loan portfolio is actually growing. They’re just a little less profitable because of interest rate conditions right now. It could be an offset because banks are a funny business in the sense that earnings don’t always reflect its profitability and the growth metrics in terms of revenue and earnings don’t really reflect the growth of the business necessarily, because it’s so tied to these underlying conditions like interest rates that the banks have no real control over. I mean, they do, but you can’t just raise interest rates because then the other banks are going to get all the business. [laughs] They’re definitely dictated by the market and by what the Fed is doing and just prevailing conditions.

Jason Moser: Let’s wrap up the conversation today with this final metric. This one is fascinating to me because I think it applies to a lot of these fintech companies that we talk about today as opposed to maybe just your stereo typical bank. Take rate is a metric which I think it’s interesting because it goes well beyond even financials. You think about a company like Etsy, for example. You’ll see Etsy talking about their take rate. What is take rate and why should we be paying attention to it?

Matt Frankel: Think of take rate as a percentage fee for providing a service.

Jason Moser: How much they take from it, right?

Matt Frankel: Right. In FinTechs this is usually used in context of payment processing. If, say, Square or PayPal processes payments, they might take 2, 3 percent of the payment volume. That might get split up to a bunch of third-parties like Visa and MasterCard, whoever issued the card in the first place, the network operators, things like that. But take rate is a percentage of gross payment volume or gross merchandise volume that represents the company’s revenue. For Amazon or e-commerce companies, you’ll see this like listing fees or things like that. It’s not just the financial specific metric, but with FinTechs, especially, it’s really very handy.

Jason Moser: PayPal another good example there. You see these companies talk about a take rate in a 2 percentish range, which seems like a pretty reasonable one. When you talk about changes in a mature companies take rate, you’re not talking about something that’s going from a 2 percent to a 4 percent. That’s not really something that’s going to happen. A material change in the take rate from PayPal would be going from like 2.1 percent to 2.4 percent. Really it is something that matters. It seems like it’s very connected to, like you mentioned, that total payment volume that’s going through that network. So they are businesses that are really based on volume and that’s why take rate is so important to those businesses.

Matt Frankel: It’s a metric that these companies really can’t compete on as much as you might think. As I mentioned, a lot of the take rate with Square, PayPal and the others are passed on to third-parties who want their money. The actual amount that is kept by these FinTechs is unusually paper thin. So there is really not that much wiggle room in the take rate. It’s like generally interest rates with these big banks. They are set by the market, they’re not set by the companies. It is interesting when you see Square process $43 billion of payments last quarter, what does that mean to the business?

Jason Moser: Exactly.

Matt Frankel: That’s what take rate tells you.

Jason Moser: That’s a really good point. I’m glad you mentioned that because it’s so easy to look at those massive numbers. PayPal pushing $1.25 trillion through all of its networks, and it’s like, wow, that business has got to be killing it. It’s worth remembering that they’re just getting a very minute little sliver of that 1.25 trillion. So it really does matter for these businesses to grow that total payment volume because that’s ultimately how they grow the business. Because that take rate is going to hang in there at a pretty steady rate, but that’s why we focus on that total payment volume so much. [MUSIC] Because it is really what can fuel the profitability of this business. It’s always nice talking with you. I really appreciate your insight here. Thanks so much for taking the time.

Matt Frankel: Of course. Anytime.

Chris Hill: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what your hear. I’m Chris Hill. Thanks for listening. We’ll see you tomorrow.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.