- By Dave Ahern
Banks are either hated or loved, depending on when you ask customers.
If they've been approved for that loan or denied a refund of any fee, you will get different answers. As a value investor, banks and financial institutions can be frustrating to try to value. They don't fall into the same category that other companies do so they often get ignored. Today we will continue with our series of looking at the different formulas that can help us unravel the mysteries of these institutions. In this post, we will delve into the efficiency ratio, what it means and how to calculate it.
The intrinsic value of WFC
"In the end, banking is a very good business unless you do dumb things." - Warren Buffett
The cool thing about learning to value banks is that once you learn how to analyze one, you pretty much can analyze all of them. There are about 500 banks that trade on the major exchanges so this should give you plenty of options to choose.
Now, don't get me wrong; they can be very complicated with all the financial instruments, heavy regulations, old account rules, macro factors and the intentionally vague jargon to try to throw you off.
But at their core, all banks are similar in that they borrow money at one interest rate and then, hopefully, lend it out at a higher interest rate, pocketing the spread between the two, which is the main avenue that banks use to make money.
"You don't make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on." - Warren Buffett
Definition of efficiency ratio
The efficiency ratio is calculated by dividing the bank's noninterest expenses by their net income. Banks strive for lower e fficiency ratios since a lower e fficiency ratio indicates that the bank is earning more than it is spending. A general rule of thumb is that 50% is the maximum optimal e fficiency ratio.
Sounds and looks pretty simple, doesn't it? And as ratios go it is pretty simple and straightforward.
But there are some accounting terms I want to go over so we understand what it is we are looking at and what the terms mean so we comprehend the meaning behind this ratio.
The nice thing about this ratio is that we don't need a degree in finance to figure it out or years in banking to decipher the meaning behind it.
This ratio is nothing more than a bank's operating costs, referred to on a bank's income statement as "noninterest expenses," divided by its net revenue (a bank's total revenue minus interest expense).
Efficiency Ratio = Net Interest Income + Noninterest Income - Provision for Credit Losses / Noninterest Expenses
Pretty simple, huh? No higher math here, just need to explain some accounting terms so we understand where the numbers are coming from and what impact they have on our formula.
First, we will only be using the data from the income statement to calculate this formula so that is easier.
Next, let's break down each term in the formula so you understand what they mean.
Net interest income: Net interest income is the difference between the revenue generated from a bank's assets and the expenses associated with paying out its liabilities. A typical bank's assets consist of all forms of personal and commercial loans, mortgages and securities. The liabilities are the customer deposits. The excess revenue generated from the interest earned on assets over the interest paid out on deposits is the net interest income.
The types of assets earning interest for the bank can vary radically from mortgages, car loans and personal loans to commercial real estate loans. This product mix will greatly affect the interest rate a bank earns on its assets. For example, Wells Fargo (WFC), the nation's largest home mortgage lender, can have big fluctuations in their interest earned based on what types of mortgage interest rates their customers carry.
If they have fixed or variable rates on their mortgages, then the interest rates they earn can vary as well. The fluctuation in interest rates can make Wells Fargo sensitive to interest rate fluctuations in the housing market.
Quality of the loan portfolio is also a factor affecting net interest income as situations like a crumbling economy and losses of jobs can cause borrowers to miss payments, which can lower the bank's net interest income.
As per usual when you read through a company's 10-k you will find differences in how these terms are laid out. Some banks are going to be more open and have many more line items laying it all out for you.
Others will be a little more closed up about revealing all the information easily. It will all be listed, but you will have to do a little more digging.
Noninterest income: Noninterest income is a bank and creditor income derived primarily from fees including deposit and transaction fees, insufficient funds (NSF) fees, annual fees, monthly account service charges, inactivity fees, check and deposit slip fees and so on.
Institutions charge fees that provide noninterest income as a way of generating revenue and ensuring liquidity in the event of increased default rates. Credit card issuers also charge penalty fees, including late fees and over-the-limit fees.
Noninterest income is the fun one and the one for which most customers hate banks the most.
This category is used by banks as a source of revenue when the interest rates are low like they have been for the last eight years. They will use this category as a marketing tool when interest rates are high.
Financial institutions and banks make the majority of their money from the sale of money. Borrowing money and then lending it out at a higher interest rate than they borrow it for is the bread and butter of most banks.
Banks will lean on the fees from this category when interest rates are low, and some banks will rely more on fees from automated teller machines while other banks will rely on general transaction fees.
Business banking is a big driver of fees as there tend to be fewer incentives to reduce fees for businesses, usually viewed as the cost of doing business.
Noninterest expense: Noninterest expenses can include employee salaries and benefits, equipment and property leases, taxes, loan loss provisions and professional service fees. Companies will offset noninterest expenses by generating revenue through noninterest income.
Employee compensation (salaries and benefits) usually make up the largest component of a bank's noninterest expenses. Usually, these expenses are related to activities that are not involved in targeting customers to deposit money in the bank.
Keep in mind that these expenses are before removing income tax expenses from the income to arrive at the net income. But that is a whole different discussion.
Provision for credit losses: This term is not one of the variables listed in the formula. But it is a line item that needs discussion.
"The provision for credit losses is treated as an expense on the company's financial statements as expected losses from delinquent and bad debt or other credit that is likely to become the default and unsatisfied (default probability)."
This provision is an estimation of potential losses that a company might experience due to credit risk, or people defaulting on their loans.
This line item is written off after the net interest income line because the banks will earn interest income from these loans, but they will default and need to be subtracted from the net interest income to balance the income earned.
OK, now on to the use of the formula of some banks.
Efficiency ratios of the leading banks of the Standard & Poor's 500
In this section, we will look at the income statements of some of the leading banks and find their efficiency ratios using our formulas. And for comparison's sake, we will look at the numbers for the last three years for any trends, or anomalies, we might find.
Efficiency Ratio = Noninterest Expenses / Net Interest Income + Noninterest Income - Provision for Credit Losses
First up, Wells Fargo.
As a note, all numbers will be in the millions unless otherwise stated.
So now we will plug some numbers into our formula to see our results. First, we will do 2016.
Noninterest expense = $52,377.
Noninterest income = $40,513.
Net-Interest income = $47,574.
Provision for credit losses = $3770.
Efficiency ratio for 2016 = $52,377 / $40,513 + $47,574 - $3770
Efficiency ratio = 62.11%
Next we will take a look at 2015
Noninterest expense = $49,974.
Noninterest income = $40,756.
Net-Interest income = $45,301.
Provision for credit losses = 2442
Efficiency ratio for 2015 = 49,974 / 40,756 + 45,301 - 2442
Efficiency ratio = 59.76%
Finally we will take a look at 2014
Noninterest expense = $49,037.
Noninterest income = $40,820.
Net-Interest income = $43,527.
Provision for credit losses = 1395.
Efficiency ratio for 2014 = 49,307 / 40,820 + 43,527 - 1395
Efficiency ratio = 59.44%
Interesting results, as you can see they have gradually risen for the last three years. This is something as an investor you would want to watch or look further into as it could be leading to some problems.
With all the problems that Wells has faced recently, this would be an area that would bear watching if you were interested in investing in it.
Of course, we wouldn't base our decision solely on this one formula but with a more detailed valuation based on a much broader look into the company.
This could be troubling because it could indicate that the bank is not as profitable as it once was. One area to watch would be the salaries under the noninterest expense section. Recently Wells Fargo announced that it was going to be raising the pay of all of the tellers companywide to offset the recent reduction in incentives.
Additionally, they were going to be raising the salaries of their bankers as well, again to offset the elimination of incentives. The increase in salaries will have an impact on the profitability of the bank in the short term and bears watching to see how it will play out over the long term.
Next, we will take a look at JPMorgan (JPM).
Again, unless otherwise stated all numbers will be in the millions.
As you can see it lays out its 10-k a little different than Wells Fargo, and it labels its salaries differently - compensation expense.
We will do the same analysis of the ratio for all three years.
Efficiency ratio for 2016
Noninterest expense = $55,771.
Noninterest income = $49,585.
Net-Interest income = $46,083.
Provision for credit losss = 5361.
Efficiency ratio for 2016 = 55,771 / 49,585 + 46,083 - 5361
Efficiency ratio for 2016 = 61.75%
Efficiency ratio for 2015
Noninterest expense = $59,014.
Noninterest income = $50,033.
Net-Interest income = $43,510.
Provision for credit losses = 3827.
Efficiency ratio for 2015 = 59014 / 50033 + 43510 - 3827
Efficiency ratio for 2015 = 65.77%
Efficiency ratio for 2014
Noninterest expense = $61,274.
Noninterest income = $51,478.
Net-Interest income = $43,634.
Provision for credit losses = 3139.
Efficiency ratio for 2014 = 61274 / 51478 + 43634 - 3139
Efficiency ratio for 2014 = 66.62%
As you can notice, there is a trend in the other direction with JPMorgan, a reduction in its efficiency ratio, which is a great thing, and looking into why that is several factors stood out to me.
First is a large reduction in other expenses under the noninterest expense section. Another item that stood out was an increase in its interest income, which means it is making a better spread on its loan products or that it is lending money out for a better interest rate than the the money it is borrowing. Thus, making a better spread on its rates.
Both of these factors will contribute to an increase in the profitability of the bank.
Next up we will look at US Bank.
As before all numbers stated will be in the millions unless otherwise stated.
I apologize for the two pictures, but US Bank lays out its 10-k in such a way that it was only possible to break it up into two pictures.
Plugging the numbers into our formula, we will get:
US Bank Efficiency Ratio
Provision for Credit Losses
As I would have expected, as US Bank has a reputation for being highly efficient and very profitable, its ratios are the best we have seen so far. Any number around 50% is our goal, and these are pretty good.
Next up we will take a look at Bank of America (BAC).
And plugging our numbers into the formula, we will get:
Bank of America Efficiency Ratio
Provision for Credit Losses
We can see there is a huge dropoff from one year and then a gradual reduction from there. The discrepancy would require some looking further into.
As I was looking at its income statement, I noticed there was a line item under the noninterest expense, other general operating that was a simply huge number in 2014, $24,844, which has since returned to normal levels.
If you were so inclined, which can be found in the actual 10-k, which I took the time to look for because I was curious. It appears there was a $15.2 billion litigation expense in 2014 that did not occur in 2015 or beyond.
What that litigation was for, I am not sure, and frankly, I don't care because I am not interested in investing in Bank of America at this time.
As we can see from above, this is an extremely easy formula and calculation to perform. Not like the dividend formulas that we have done in the recent past.
This formula also gets us closer to our final goal, which is to learn how to value a bank. These can be valuable assets to own, but because the valuations are a little different, it can take us some time to learn the correct way to find our intrinsic value.
The efficiency ratio is important for two reasons. First, it tells us approximately how much of the bank's net revenue will be available for:
Setting aside for future loan losses or loan loss provisions.
Paying our taxes.
Distributing back to shareholders via dividends or buybacks.
Going to the bottom line and contributing to the bank's book value.
As we will see in future articles, the fourth point is particularly important because a bank's book value per share contributes mightily to the price of its stock. If a bank has a high book value per share, it will have a high share price and vice versa.
The second reason the efficiency ratio is important is that there is a very sharp correlation between a bank's efficiency and its tendency to underwrite good loans - meaning that efficient banks have to charge off fewer loans than inefficient banks.
The correlation is pretty clearly outlined in our above examples, the more inefficient the bank, the higher the write-offs for loans.
This all leads to a reduction in the bottom line and a much lower book value per share.
All the above reasons illustrate why I think this is a very important ratio to consider when valuing a bank. And will be instrumental to us as we move forward with this process.
Next week we will tackle Return on Assets as we continue our path towards being able to value a bank or financial institution confidently.
As always, thank you for taking the time to read this article. I hope you find some value in it.
Please let me know if you have any questions or comments on this article, or if you would like to have any help with any of these formulas.
Disclosure: The author is long Wells Fargo, has no positions in the other stocks mentioned and has no plans to initiate any.
This article first appeared on GuruFocus.
The intrinsic value of WFC