The analysis of banks and banking stocks can be challenging because banks operate and generate profit in a fundamentally different way than most other businesses. While many other industries create or manufacture products for sale, the primary product a bank sells is money.
Investors and market analysts use specific financial ratios to evaluate companies in the retail banking industry. Common ones are the net interest margin, the loan-to-assets ratio, and the return-on-assets (ROA) ratio.
Key Takeaways
- Net interest margin reveals a bank’s net profit on interest-earning assets, such as loans or investment securities.
- Banks with a higher loan-to-assets ratio derive more of their income from loans and investments.
- Banks with lower levels of loan-to-asset ratios derive a larger portion of their total incomes from more diversified, non-interest-earning sources, such as asset management or trading.
- The return-on-assets ratio is a profitability ratio, indicating the per-dollar profit a company earns on its assets.
The Retail Banking Industry
The retail banking industry includes those banks that provide direct services such as checking accounts, savings accounts, and investment accounts, along with loan services, to individual consumers. However, most retail banks are commercial banks that service corporate customers as well as individuals. Retail banks and commercial banks typically operate separately from investment banks, although the repeal of the Glass-Steagall Act legally allows banks to offer both commercial banking services and investment banking services. The retail banking industry, like the banking industry overall, derives revenue from its loans and services.
In the United States, the retail banking industry is divided into the major money center banks. The big four are Wells Fargo, JPMorgan Chase, Citigroup, and Bank of America. In addition to those, there are regional banks and thrifts.
In analyzing retail banks, investors consider profitability measures that provide performance evaluations considered most applicable to the banking industry.
The financial statements of banks are often more complex to analyze than those of companies engaged in other types of business.
While investors considering bank stocks look at such traditional equity evaluation measures as price-to-book (P/B) ratioor price-to-earnings (P/E) ratio, they also examine industry-specific metrics to more accurately evaluate the investment potential of individual banks.
Net Interest Margin
Net interest margin reveals a bank’s net profit on interest-earning assets, such as loans or investment securities. Since the interest earned on such assets is a primary source of revenue for a bank, this metric is a good indicator of a bank's overall profitability. Higher margins generally indicate a more profitable bank.
Many factors can impact the net interest margin, including interest rates charged by the bank and the source of the bank's assets. Net interest margin is calculated as the sum of interest and investment returns minus related expenses; this amount is then divided by the average total of earning assets.
Loan-to-Assets Ratio
The loan-to-assets ratio is another industry-specific metric that investors can use to analyze a bank's operations. Banks that have a relatively higher loan-to-assets ratio derive more of their income from loans and investments. Banks with lower levels of loans-to-assets ratios derive a larger portion of their total incomes from more diversified, non-interest-earning sources, such as asset management or trading.
Banks with lower loan-to-assets ratios may fare better when interest rates are low or credit is tight. They may also fare better during economic downturns.
Return-on-Assets Ratio
The return-on-assets (ROA) ratio is frequently applied to banks because the cash flow analysis is more difficult to accurately construct. The ratio is considered an important profitability ratio, indicating the per-dollar profit a company earns on its assets. Since bank assets largely consist of money the bank loans, the per-dollar return is an important metric of bank management.
The ROA ratio is a company's net, after-tax income divided by its total assets. Since banks are highly leveraged, even a relatively low ROA of 1 to 2% may represent substantial revenues and profit for a bank.
What's the Difference Between Retail Banking and Corporate Banking?
Retail banks direct their services, such as deposit and lending services, toward individuals consumers. Corporate banks provide the same services but to businesses, governments, and other large organizations. The division between the two types of bank is not always straightforward, as many banks offer both retail and corporate banking services.
Why Are Retail Banks Highly Leveraged?
A company is said to be highly leveraged if it has a high level of debt for its industry. Retail banks, however, are often highly leveraged due to the nature of their services. Banks use their own capital to make loans and investments.
What Financial Ratios Should Investors Use for Retail Banks?
Investors can use the net interest margin, the loan-to-assets ratio, and the return-on-assets (ROA) ratio to analyze retail banks. These can be used to analyze a bank's profitability, as well as to understand whether a bank generates more income from loans or other assets.
The Bottom Line
The banking industry is structurally different from many other industries since its primary product is money. As a result, investors and financial analysts must use specific financial ratios when analyzing the profitability of retail banks.
Common ratios used are the net interest margin, the loan-to-assets ratio, and the return-on-assets (ROA) ratio. Net interest margin is used to analyze a bank’s net profit on interest-earning assets like loans, while the return-on-assets ratio shows the per-dollar profit a bank earns on its assets. The loan-to-assets ratio indicates where a bank gets most of its income; a bank with a higher loan-to-assets ratio generates more income from loans and investments, while a lower ratio indicates income from non-interest-earning sources, such as trading or asset management.
