The importance of understanding bank stock valuations

As a prospective investor in banking shares, it’s important to do the homework before jumping in. Evaluating the share value of any bank involves an analysis of the various elements of banking, the levels of risk, and profitability. 

These differ depending on the type of bank and what market they serve. It depends on whether the bank in question focuses on loans or investments, whether they are long or short term, and the extent of unrealized repayments. They may offer a healthy mix of products, but it is necessary to analyze their current assets and liabilities and how efficiently they are being managed.

Before considering an investment, it is essential to understand the fundamentals of banking. Learn how to do the calculations and assessments that go into determining the financial health and long-term growth prospects of the bank.

Keep an eye on bank websites as well as reliable financial press releases regarding performance achievements and general market trends, take this report on the Bank of New York Mellon (BNY) profit increases, for example. The BNY team shares helpful insights into investing and wealth creation, as well as a comprehensive account of current and historical financial results.

What are the key factors that influence bank stock valuations?

Regulatory requirements and costs

Banks are required to comply with regulations set down by the various institutions. This ensures that there is a sufficient capital reserve buffer to absorb possible losses. Being complaint involves expenses though, and this in turn affects the bank’s profitability. Changes in compliance with regulations can also affect a bank’s operations and its ability to generate profits until the necessary adjustments are made.

Sensitivity to interest rates

The bank’s net interest margin (NIM) is determined by calculating the difference between interest paid and interest received. If it pays more interest on deposits than it receives on loans, then its NIM decreases. 

When interest rates rise and the bank leans toward issuing long-term fixed deposits, it may suffer losses. On the other hand, a predominantly short- to medium-term mix with variable interest rates would be beneficial in the midst of rising rates.

Non-interest income sources

As a buffer against losses incurred by interest rate fluctuations, banks earn additional revenue by offering advisory and brokerage services, as well as asset and estate management facilities.

Trading and investment incomes

Trading always comes with an element of risk and volatility. Take a good look at historical statistics to determine whether trades have been successful and at the credentials of the trading team.

Income from investments is another lucrative non-interest source of income. It is likely that the bank will have some valuable assets but be wary of overinvestment in properties that have the potential to become redundant due to shifting patterns in the estate market.

Loan portfolios

Diversification is key to reducing risk. A high level of non-performing loans (NPLs) increases the risk. NPLs are loans that have not been realized, either fully or partially.

Economic growth conditions

Economic growth results in increased borrowing at lower rates. This benefits banks in the short term – however, when economic growth declines, so do bank loans, and the tendency for repayment defaults increases.

Understanding the metrics

Return on equity (ROE)

This is the net profit generated on the equity investments contributed by the bank’s shareholders. The ROE profitability ratio is used to determine the efficiency of the bank.

Efficiency ratio

This is the ratio of non-interest expenses to net revenue. It is calculated as expenses (excluding interest) / revenue.

It shows how well banks control their overhead expenses: the lower the ratio, the better the indications are that the bank is well managed.

Loan-to-deposit ratio

This is the proportion of loans granted to clients in relation to deposits received. The higher the ratio, the more risk is involved. Conversely, a low ratio means conservative management.

Non-performing loan (NPL) ratio

Non-performing loans (NPLs) related to late or incomplete repayment will increase the bank’s risk levels and indicate the potential for profitability losses in the long term.

Working with the factors and metrics to produce answers

A fundamental analysis of the bank’s financial statements – balance sheets, income statements and cash flow – will give an indication of the financial status of the bank. Combine this with the ratio calculations outlined above for an insight into risk levels and performance.

A comparative analysis performed on the bank’s metrics against industry standards, as well as on the performance of its peers, will provide insights into the bank’s strengths and weaknesses. 

Valuation models

Valuation models that can be used in this exercise include:

• Price-to-earnings ratio (P/E): current market value per share / earnings per share.
• Price-to-book ratio (P/B): current market price per share / book value per share.
• Discounted cash flow (DCF): project future cash flows and discount them to current values.
• Dividend discount model (DDM): project future dividends and value them at current rates.

Due diligence pays off

It may sound daunting at first, but having a thorough understanding of the process is half the battle. The other half is taking the time to do the research and perform the calculations and comparisons. Rest assured that it’s time well spent.

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